What is the effect on interest rates when the price level decreases?

When the price level decreases, it tends to lead to a decrease in interest rates. This relationship is primarily rooted in the dynamics of the money supply and demand for money within the economy.

As the price level falls, the real value of money increases, which means that consumers and businesses need less money to purchase the same quantity of goods and services. With less demand for money at lower price levels, banks and financial institutions have more liquidity available. To encourage borrowing and spending, they may lower interest rates.

Additionally, decreasing price levels can signal lower inflation expectations. Lower inflation rates typically lead to lower nominal interest rates, as lenders require less compensation for the erosion of purchasing power over time. In essence, if consumers expect prices to remain stable or decline, they are less likely to take out loans at higher interest rates, leading lenders to reduce interest rates to entice borrowers.

Therefore, a decrease in the price level effectively contributes to lower interest rates, validating the response that interest rates decrease when the price level decreases.