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What Is the Connection between Price Level and Interest Rate?

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  • Written By: Esther Ejim
  • Edited By: Kaci Lane Hindman
  • Last Modified Date: 10 September 2016
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Price level and interest rate are linked together in the sense that the manipulation of the level of interest rates is one of the tools used by the central bank or government to control price levels in an economy. The central bank in a country uses interest rates as one of its main tools for either increasing or decreasing price levels, both to different effects. When the price level is too high, the central bank will increase the interest rates. When the price level is too low, the central bank will decrease the interest rates.

Increasing the interest rate affects the level of the aggregate price in an economy by reducing the capacity of consumers to obtain money with ease from banks. Normally, central banks aim to maintain the interest rates at a predetermined low percentage as much as possible. When the market is too active and the excessive demand for goods and services start to push the prices of such items ever upward, the central bank will seek to curtail the activities on the market. Price level and interest rate are linked together by the fact that an increase in the interest rates will cause a decline in the price of goods.

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By increasing the interest rates, consumers will not have the same easy access to different types of credit and loans, which they can use to finance purchases like cars, clothes, houses and other items. When consumers no longer have the means to pay for such things, the demand for them will drop and the prices will drop too. This link between price level and interest rate means that the drop in demand caused by interest rates increase will lead to a situation where the supply will outweigh the demand. Normally, when the supply is more than the demand, the prices of goods and services will drop in response.

Another relationship between price level and interest rate can be seen in a situation where there is a deflation or the price level is lower than average. Such a situation is usually the outcome of too little demand on the part of consumers for the finished products in the market. In this situation, the central bank will decrease the interest rates in an effort to induce consumers to obtain more money from banks and make more purchases. When the central bank decreases interest rates, other banks also react by decreasing the interest rates on savings account, making it less enticing for customers to save money.

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Terrificli
Post 3

@Logicfest -- I don't know. An all cash system would make people more fiscally responsible. Heck, we might even wind up with a government that actually stayed out of debt. The national government reflects the spending habits of her citizens, and we have been a terrible example in the United States.

Oh, I know we will never be on an all cash system. Still, it is something worth discussing, isn't it?

Logicfest
Post 2

@Soulfox -- Prices may be lower, but who could afford to buy anything? Like it or not, credit is a critical component to the economy. Without it, the United States would not have the high standard of living it enjoys.

Here's what I mean. When you buy that house or that car, then that means jobs are created to build more houses and cars. Make credit unavailable, and those houses and cars will cost less. That means either salaries will drop considerably or there will be fewer jobs available (probably both).

Also, there would be fewer of those houses and cars made, and that also leads to fewer jobs and lower wages.

I realize that abuse of credit is a real problem in this country, but it is a necessary evil. The best thing the government could do would be to teach people how to use credit responsibly.

Soulfox
Post 1

Isn't the reason prices are so high is because credit is easily available? Banks may talk about rising interest rates and credit that is harder to get at times, but credit is a lot easier to get than we have been led to believe.

If we relied mostly on cash to purchase things, prices of cars, homes and everything else would drop considerably. Because of credit, people don't much care what they pay for things and prices naturally increase as a result.

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