The Determination of the Natural Rate of Interest in Wicksell's System, and Its Relevance to the Determination of the Price Level
Wicksell's theory and explanation
Knut Wicksell is known for his theories on interest and prices, and his contribution to the formation of what is now called macroeconomics. Throughout his career, Wicksell was an advocate of the quantity theory. In the book Lectures in Political Economy, volume 2, Wicksell sketched out his version of the quantity theory of money. Before Wicksell, the standard view of the quantity theory was that there is a direct effect on prices from an increase in the money supply. Wicksell focused on the indirect effect (Wicksell, 1906). In explaining this effect, he distinguished between the actual money rate of interest and the real rate of return on new capital (the “natural rate of interest”). He argued that if the banks reduced the rate of interest below the real rate of return on capital, the amount of loan capital demanded would increase and the amount of saving supplied would fall (ibid). Investment, which equalled saving before the interest rate fell, would exceed saving at the lower rate. The increase in investment would increase overall spending, thus driving up prices. This “cumulative process” of inflation would stop only when the banks’ reserves had fallen to their legal or desired limit, which ever was higher (ibid).
Keynes’ General theory had included other dynamics such as aggregate demand and supply in addition to interest rates determines price levels, which seemed to be influenced by the works of Wicksell (Dome, 1994).
In his paper “the influence of the rate of interest on prices” that was read before the Economic Section of the British Association in 1906, Wicksell mentioned that Interest on money and profit on capital are not the same thing, nor are they immediately connected with each other; if they were, they could not differ at all, or could only differ a certain amount at every time. There is no doubt some connecting link between them, but the proper nature and extent of this connection is not so very easy to
Knut Wicksell is known for his theories on interest and prices, and his contribution to the formation of what is now called macroeconomics. Throughout his career, Wicksell was an advocate of the quantity theory. In the book Lectures in Political Economy, volume 2, Wicksell sketched out his version of the quantity theory of money. Before Wicksell, the standard view of the quantity theory was that there is a direct effect on prices from an increase in the money supply. Wicksell focused on the indirect effect (Wicksell, 1906). In explaining this effect, he distinguished between the actual money rate of interest and the real rate of return on new capital (the “natural rate of interest”). He argued that if the banks reduced the rate of interest below the real rate of return on capital, the amount of loan capital demanded would increase and the amount of saving supplied would fall (ibid). Investment, which equalled saving before the interest rate fell, would exceed saving at the lower rate. The increase in investment would increase overall spending, thus driving up prices. This “cumulative process” of inflation would stop only when the banks’ reserves had fallen to their legal or desired limit, which ever was higher (ibid).
Keynes’ General theory had included other dynamics such as aggregate demand and supply in addition to interest rates determines price levels, which seemed to be influenced by the works of Wicksell (Dome, 1994).
In his paper “the influence of the rate of interest on prices” that was read before the Economic Section of the British Association in 1906, Wicksell mentioned that Interest on money and profit on capital are not the same thing, nor are they immediately connected with each other; if they were, they could not differ at all, or could only differ a certain amount at every time. There is no doubt some connecting link between them, but the proper nature and extent of this connection is not so very easy to