<p>It is not inconsistent per se since there are more than just one channels through which price level and interest rate interact.</p>
<p>For example, in a IS-LM AS-AD, model when central bank decreases interest rate, initially LM curve shifts down, which leads to higher price level (so they move opposite to each other) and lower output (lower output is caused by movement along IS curve - e.g. people consuming less due to higher interest rate). However, as a result of higher price level people now demand higher real money balances which shifts LM curve back up and interest rate increases (here price level moves in same direction as interest rate). The economy ends up with the previous rate of interest and much larger price level (draw horizontal line from A'').</p>
<p>This is probably best understood graphically, the graph below (from Blanchard et al Macroeconomics 2nd ed pp 171) visualizes what I have written above. Please ignore in the graph LM'', that part shows what would happen if price level was fixed which is not relevant for your question or this answer.</p>
<p>As you can see from the graph, both statements are completely consistent with each other. Economy is an endogenous and highly complex system, often change in one variable will have different effect in short/medium/long run, and even in the same time span one variable can trigger through various channels effects that counteract each other. This is not sign of inconsistency, economics is not like physics where many forces are exogenous and less complex.</p>
<p><a href="https://i.sstatic.net/UDedWsOE.png" rel="nofollow noreferrer"><img src="https://i.sstatic.net/UDedWsOE.png" alt="enter image description here" /></a></p>

CC BY-SA 4.0
2024-12-13T22:40:45.987Z
2024-12-13T22:47:58.860Z
2024-12-13T22:47:58.860Z
1muflon1
<p>I read that when interest rate goes up, price level tends to decrease as a result of consumption and investment going up. This implies that the two moves in opposite direction.</p>
<p>But at the same time, when price level increases, people need more money in their business and so money will be taken away from bank and interest rate goes up.</p>
<p>This seems inconsistent as the first statement tells us the price level and interest rate moves in the same direction, while the second implies that they move in opposite directions.</p>
<p>How can this happen?</p>

CC BY-SA 4.0
2024-12-13T13:00:15.073Z
please, add the source where you read these claims. May be it has some model?
garej
<macroeconomics><fiscal-policy>
Relationship between interest rate and price level
Willow
# Relationship between interest rate and price level

(Asked by: username_0 on 2024-12-13)

I read that when interest rate goes up, price level tends to decrease as a result of consumption and investment going up. This implies that the two moves in opposite direction.

But at the same time, when price level increases, people need more money in their business and so money will be taken away from bank and interest rate goes up.

This seems inconsistent as the first statement tells us the price level and interest rate moves in the same direction, while the second implies that they move in opposite directions.

How can this happen?

**Tags:** macroeconomics, fiscal-policy

> **Comments:**
> **username_1**: please, add the source where you read these claims. May be it has some model?  

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## 1 answers

### Answer by username_2 on 2024-12-13. Score: 1

It is not inconsistent per se since there are more than just one channels through which price level and interest rate interact.

For example, in a IS-LM AS-AD, model when central bank decreases interest rate, initially LM curve shifts down, which leads to higher price level (so they move opposite to each other) and lower output (lower output is caused by movement along IS curve - e.g. people consuming less due to higher interest rate). However, as a result of higher price level people now demand higher real money balances which shifts LM curve back up and interest rate increases (here price level moves in same direction as interest rate). The economy ends up with the previous rate of interest and much larger price level (draw horizontal line from A'').

This is probably best understood graphically, the graph below (from Blanchard et al Macroeconomics 2nd ed pp 171) visualizes what I have written above. Please ignore in the graph LM'', that part shows what would happen if price level was fixed which is not relevant for your question or this answer.

As you can see from the graph, both statements are completely consistent with each other. Economy is an endogenous and highly complex system, often change in one variable will have different effect in short/medium/long run, and even in the same time span one variable can trigger through various channels effects that counteract each other. This is not sign of inconsistency, economics is not like physics where many forces are exogenous and less complex.

[![enter image description here](https://i.sstatic.net/UDedWsOE.png)](https://i.sstatic.net/UDedWsOE.png)


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