Interest and prices
Wicksell’s special version of the equation of exchange amounted to treating the monetary base as invariable and the velocity of its circulation in terms of bank deposits as infinitely variable.
With this trick and the insight that loans create deposits, he set the focus on the level of loan rates as their main determinant. The decisive factor is not this “market rate of interest” per se, but its changes in proportion to the prospective rate of return on real investment - or rather, its inertia in view of ever-changing yields on real investment. For the latter, Wicksell (1898 [1936]: ch. 8) used a physical concept as a virtual benchmark for monetary equilibrium, even though he was well aware of the problems of measuring the marginal productivity of capital in physical units. Referring to the competitive equilibrium of a (fictitious) barter economy, he defined as “the natural rate of interest” the rate of return that would match aggregate investment and saving if all borrowing and lending were made in kind, that is, in the form of real capital goods. In more general definitions, he used the notions of a “neutral” or “normal rate of interest” with reference to the market rate that leaves the price level unchanged, as the cost of financing investment projects corresponds to the latter’s marginal return.Wicksell argued that the optimizing behaviour of commercial banks tends to make the market rate of interest sticky, whereas the natural rate is highly variable. It depends on the impact of innovations, disasters and other factors that affect supplies and demands - in short, “on all the thousand and one things which determine the current economic position of a community; and with them it constantly fluctuates” (Wicksell 1898 [1936]: 106). Once the natural rate rises above the money rate of interest, it becomes profitable for entrepreneurs to borrow additional funds for new investments.
Given the conventionally required collaterals (whose values tend to rise during a credit boom), it will also be profitable for the banks to lend, and thus the supply of deposit money adjusts endogenously to the demand for credit. Under Wicksell’s standard assumption of full employment, aggregate demand exceeds aggregate supply and goods prices will start to rise. The upward movement of prices will become self-reinforcing over time. It will “create its own draught” (1898 [1936]: 96), as expectations of further inflation begin to enter the process of price formation.The cumulative process of changes in the price level will continue as long as there remains a gap between the money rate of interest and the neutral rate. Wicksell (1898 [1936]: 117) asserted that the gap will always be closed by a convergence of the market rate of interest on the natural rate: “[T]he Bank rate, or more generally the money rate of interest, will always coincide eventually with the natural capital rate, or rather that it is always tending to coincide with an ever-changing natural rate.” However, as Wicksell’s critics Davidson, Cassel and Ludwig von Mises pointed out, he failed to explain why that should happen in a pure credit economy at all, and why it would not lead to the adjustment of the rate of return on real investment to the market rate of interest, rather than vice versa.
Wicksell considered cumulative deflation to be essentially symmetric to inflation. He admitted that a fall of the natural rate of interest below the market rate might not only lower the price level, but output and employment, too. Yet he considered such real effects to be of second-order and non-cumulative.
Apart from what has been pointed out above, Wicksell’s theory of cumulative changes in the price level is noteworthy for at least five reasons. The first is that it provided one of the earliest frameworks of macroeconomic analysis, in which the movements of prices and quantities in the markets for goods, finance and labour were systematically connected at the aggregate level.
The second reason is its clear conceptualization of inflation and deflation as interacting failures of the inter- and intra-temporal price mechanisms. Every change in the unobservable “natural rate of interest” carries the risk that the observable intertemporal price, embodied in the money rate of interest, fails to coordinate investment with planned saving. As a consequence the intra-temporal price mechanism in the goods markets will translate the excess demands for present goods into a rise in the price level. A “false price” (the money rate of interest) in one market induces adjustments in other markets (for labour and goods) that do not lead to a self-correction of that price (the interest rate). The third reason is Wicksell’s fundamental distinction between the stability properties of the price structure and the price level: the system of relative prices is stable. “Every movement away from the position of equilibrium sets forces into operation - on a scale that increases with the extent of the movement - which tend to restore the system to its original position” (Wicksell 1898 [1936]: 101). In the case of the general price level, on the other hand, the final equilibrium position will differ from the original one, as market forces do not automatically correct for past inflation (or deflation). The fourth reason is that Wicksell did not see his monetary theory as an explanation of the business-cycle phenomenon. In his view, which he outlined in few sketches only, the basic cause of cyclical fluctuations is to be found in the asynchronous occurrence of technical progress and changes in aggregate demand (Wicksell 1906 [1935]: 209-14; Boianovsky and Trautwein 2001b). The fifth reason for the prominence of Wicksell’s monetary theory is the simple rule for the stabilization of the price level that he deduced from it. The current natural rate of interest is unobservable, but the rate of inflation can be ascertained with only a short lag. If it rises above zero, the central bank ought to increase its lending rates until the inflation stops. In the case of deflation, it should correspondingly lower its lending rates. In this way, monetary policy could produce a stable and relatively invariable standard of value.