The present study shows important evidence revealing an intimate relationship between the size-induced modifications of electronic structure and optical properties of Ag nanoparticles. Optical absorption spectra of Ag nanoparticles consisting of two predominant peaks corresponding to characteristic plasmon absorption due to the collective oscillations of conduction-band electrons and an interband absorption due to the transition of electrons from the completely occupied d bands to an empty state above the Fermi level in the conduction band have been observed to depend on the nanoparticle size. On the reduction of nanoparticle size, the interband absorption peak becomes sharp and intense and its peak position shifts towards the lower energy side, which is found to be associated with the size-induced changes in the d bands observed by x-ray photoelectron spectroscopy.