Natural Rate of Interest- Wicksell – Price Stability

Price Stability equated with neutral money

Wicksell’s third definition of the natural rate of interest focused on the price level. That is there is a rate of interest that tends neither to increase or decrease prices. That is, when the observable market rate of interest is at a certain level, the price level will be stable and there will be no tendency for price inflation or deflation.

Wicksell writes:

“There is a certain rate of interest on loans which is neutral in respect to commodity prices and tends neither to raise nor lower them.” Wicksell, Interest and Prices, 1898. p.188

In this situation when the natural rate and market rate is equalized you would see stable aggregate prices. Working backward into the equation, when there is no inflation or deflation, we can say that the natural rate of interest is equal to the market rate of interest.

Relative Prices versus Absolute Prices

However, this says nothing about relative prices. Relative prices could change as a result of technical process.

“It is true that as a result of changes in the conditions of production, due for instance to technical progress, first on and then another group of commodities will be obtainable with a small expenditure of labour and other factors of production, and that must cause continual disturbances in relative values. But there is no apparent reason for any alteration in the general level of money prices.” Wicksell, Interest and Prices, 1898. p.193.

An important point here is, Wicksell’s definition of the natural rate referring to general price stability needs to be seen in context. It does not go into how interest rates can affect relative prices but keep the appearance of price stability. This is taken up by the Austrian business cycle theorists.

Why all definitions of the natural rate of interest matter

It is a consequence that flows from Wicksell’s other definitions of the natural rate being filled. That is, the marginal productivity of free mobile capital being equal to the market rate, hence the demand and supply of real capital being equal, therefore, as a result, prices in a static equilibrium tend neither to rise or fall.

In other words, there are a series of conditions before price stability is reached

  • †The MPC in natura = i(market)
  • Ex-ante I=S
  • Assuming static equilibrium.
  • No increase in general productivity from technical gains that would reduce the overall cost structure of production. For example the AI revolution or in the 1920s electrification and automation.

This last point is important because if you see price stability, it does not mean that the natural rate equals the market rate or that I=S ex-ante. It could be price changes from a change in productivity.

Price stability and equilibrium

Prices metaphor to weight

This would be analogous to someone who works out, and the doctor says they are overweight because thet shows their weight as out of range. However, if this weight gain is muscle, from training this has decreased their fat percentage but increased total mass. Therefore, the doctor’s conclusions are incorrect. And his policy recommendation for the person to lose weight in incorrect. In contrast with someone who is in the normal rate of numbers, but has skinny arms and a gut. You can not just base an equilibrium on observed data without understanding what is behind the data.

Therefore, this is the weakest of Wicksell’s definition of the natural rate of interest. Better is to focus on Wicksell’s understanding of the natural rate as the rate where the in natura marginal return on newly created free mobile capital.†

Stable prices can not be considered equilibrium without a capital theory

Modern theorist miss this point. The Federal Reserves mandate of price stability and target of 2% is not only arbitrary but potentially damaging to the capital structure. In the Holston-Laubach-Williams (2017) model which estimates R-star, the modern version of the natural rate of interest, this line of thinking is not considered. It is a large theoretical oversight.

Capital theory is largely replaced with a focus on prices in a monetary economy, rules and targets. For example, Michael Woodford in his book Interest and Prices, 2003 takes Wicksell’s observable consequence of stability in Wicksell’s static equilibrium construct and applies it to a dynamic equilibrium virtually without reference to Wicksellian or Austrian capital theory. It is more about flexible prices and wages for Woodford. These have to be flexible, for the past, present, and future. Rigidities versus price flexibility is more important in his equilibrium rate than developing his theory along the lines of capital theory.

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