High Inflation and High-Interest Rates Explained

Although in historical context, interest rates and inflation that exist today are not comparable with the experience in the 1970s (I remember interest rates over 20% under Paul Volcker and inflation over 12%), compared to the data of the last 30 years, rates and inflation are high. Theory teaches interest rates and the price level to move inversely. This is a paradox when compared with observable data.

Similarly, the quantity theory of money does not seem to hold either. That is, expanding the money supply does not necessarily mean an increase in the price level.

How can this be? I can explain it simply. It’s called the mysterious Gibson Paradox.

The Gibson Paradox

The Gibson paradox refers to a puzzling phenomenon that was observed in the early part of the 20th century, where interest rates and prices seemed to move in opposite directions; precisely, during the period between 1896 and 1930, interest rates in the United States tended to rise when prices were falling, and vice versa. This was unexpected, as it was widely believed that interest rates should move in the same direction as prices.

The Gibson paradox is named after British economist Alexander Gibson, who first noted the phenomenon in the late 1920s. Gibson suggested that the paradox could be explained by changes in the demand for money, which in turn affected the velocity of circulation of money. According to Gibson, when the demand for money was high, interest rates tended to rise. Still, the velocity of circulation of money tended to fall, which resulted in a decline in prices. Conversely, when the demand for money was low, interest rates tended to fall, but the velocity of circulation of money tended to rise, which increased prices. Knut Wicksell, the Swedish economist, was partly inspired to develop his theory of the natural rate of interest to explain this.

While Gibson’s explanation provided a theoretical framework for understanding the paradox, it remained a debate among economists for many years. In the 1960s and 1970s, the paradox became even more puzzling, as interest rates and prices appeared to move in the same direction, in contrast to the earlier period.

In the decades since the Gibson paradox was first observed, economists have offered a number of different explanations for the phenomenon. Some have suggested that it may be related to changes in the gold standard, which was the prevailing monetary system at the time. Others have proposed that it may be linked to changes in the economy’s structure, such as shifts in the relative importance of agriculture and industry. However, it was Wicksell who got it right. It is the observable interest rate; the bank rate is a realistic rate. It is a reality of the marginal productivity of capital on newly created non-fixed capital goods or the expected profit rate.

In terms of data, I want to reference a lot of journal articles, but they are paying for access so it is better just to mention the data. If I were to link to anything, I would like to this Interest and Prices by Wicksell. the Gibson paradox is based on historical observations of interest rates and prices in the United States. Researchers looked at the numbers from this period and have found evidence to support the existence of the paradox. For example, one study published in the Journal of Political Economy in 1986 found that interest rates and prices were negatively correlated from 1896 to 1920 but positively correlated from 1921 to 1940. So again, what is going on? What is the data telling us?

Unknown woman in from of a Bank in New York circa 1900

Based on Swedish economists from the Stockholm school Gunnar Myrdal, Bertil Ohlin, and Erik Lindahl, a school that drew off the idea of a natural interest rate, including Mises and Hayek. I like the Austrian school of economics in some aspects. I would classify myself as a Swedish economist. The Austrians are a little too intense for me.

So the idea is interest rates might be high. Still, in relationship to the expected return on investment profit rate, they are not high enough, so entrepreneurs arbitrage between the loan rate and the expected profit rate and bid up capital goods. With the increased income, they also bid up consumer prices. To fix this problem, they simply push interest rates high.

So the central bank is increasing rates but not high enough. Not fast enough based on the natural rate of interest or the expected return on capital. As an entreprenurial aactor, you want to borrow low and earn high. So the profit rate might be 10% and if the central bank raises the rate to 5% or 7% inflation will persist because indidivdials bid up scarce resources. This puts pressure on the CPI or PPI. The converse is also true if you are speaking about deflation.

In terms of modest single diget inflation this does not seem like a big issue unless you put it in the context of the Cantillon effect or a redistribuition of wealth. Money is not neutral in the short or long run. Also variability in price changes can put a drag on economic growth, this was pointed out by Michael Woodford and the reason he advovated a rule based approach to monetary policy using the natural rate of interest.

Woodford’s points on Inflation can be summarized in the following points:

Uncertainty: Inflation creates uncertainty for consumers and businesses, making it difficult for them to plan for the future. If prices are rising rapidly, it can be hard to predict what goods and services will cost in the future, which can lead to a reduction in investment and economic activity.

  • Distortion of prices: Inflation can also distort the relative prices of goods and services. When prices are rising, it can be difficult to determine whether a change in a price reflects a change in supply or demand or simply the overall increase in prices.
  • Redistribution of wealth: Inflation can also lead to a redistribution of wealth. People with fixed incomes or savings will see the value of their money decline, while borrowers will see the real value of their debt decrease. This can create winners and losers in the economy.
  • Decreased economic growth: Finally, high inflation can lead to decreased economic growth. When prices are rising rapidly, it can be difficult for businesses to plan for the future, which can lead to a reduction in investment and hiring. This can lead to a slowdown in economic activity and reduce the standard of living for many people.

So again the inflation cure is always high interest rates. The Fed should be and inflation hawlk if they want stablizes the price level. I personally question if the price level needs stablizing but under current policy that is the action that is optimal.

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