Lesson 1 of 7
Wicksell's two rates
One rate is charged by banks. The other is what lending would cost if there were no money. Wicksell built a theory of prices out of the gap.
By Javier Sanz
Founder of ValueScreener. Built Ninety Nine, a securities services provider, and sold it to a tier-one global bank; ran operations and internationalization at Alpaca, the brokerage API.
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In one minute
- The money rate is what lenders charge. The natural rate is the rate that would be settled by supply and demand if real capital goods were lent in kind, with no money in the transaction.
- Wicksell's claim is that a money rate below the natural rate raises prices, a money rate above it lowers them, and only equality leaves them alone.
- The movement does not stop by itself. So long as the gap persists, prices go on moving in the same direction, which is why he called it a cumulative process.
Wicksell opens his eighth chapter with a rate of interest that is neutral towards commodity prices, tending neither to raise nor to lower them. He then says the same rate three ways, and each way is worth reading slowly.
The gap, and what Wicksell says happens in it
Money rate below natural
- Borrowing looks profitable at the margin.
- More projects are started than were before.
- Demand for labour, materials and land rises.
- Prices rise, and go on rising while the gap lasts.
Money rate above natural
- Borrowers fall short of their normal return.
- Business narrows to its most profitable parts.
- Demand for factors falls off.
- Prices fall, and go on falling while the gap lasts.
A rate is never high or low in itself, only against the return the borrower expects.
Three ways of saying one thing
The first statement is the neutral rate: the rate at which lending neither pushes prices up nor drags them down.
The second is the one that does the work. It is the rate that would be determined by supply and demand if no money were used and all lending were effected in real capital goods. Wicksell is careful that this is an abstraction and says so: liquid capital is never actually lent, goods are bought and sold and money is what changes hands.
The third is the shortest. It is the current value of the natural rate of interest on capital, which he says is roughly the real return of actual business.
Why the gap does not close on its own
This is the part that made the idea famous. If the money rate sits below the natural rate and prices are unchanged, entrepreneurs collect a surplus over their normal return. That surplus does not exhaust itself. It keeps accruing for as long as the two rates stay apart, so firms expand to exploit it, more people become entrepreneurs, and the demand for goods and services keeps rising.
Prices therefore do not move to a new level and settle. They move, and go on moving. Wicksell's own reasoning is that the deviation must eventually drag the money rate back into line, because the supply of real capital is limited by physical conditions while the supply of money is not.
Why an exact match is unlikely
Wicksell says the natural rate is not fixed. It depends on the efficiency of production, on the stock of capital, on the supply of labour and land, and it moves continuously. The money rate, by contrast, is changed in discrete steps by large institutions.
A continuous variable and a step function will rarely coincide. His conclusion is not that the gap is always large, only that there is no mechanism guaranteeing it is ever exactly zero.
What this lesson does not claim
Nothing here says the natural rate can be observed. Wicksell defines it by describing an economy that does not exist, one in which goods are lent without money. Whether a single such rate exists at all is the subject of the next lesson, and measuring it is the subject of the last.
Check yourself
How does Wicksell define the natural rate of interest on capital?
- The rate the central bank announces
- The rate supply and demand would settle if real capital goods were lent in kind, with no money involved
- The long-run average of the money rate
Show the answer
Answer: B.
Chapter 8 gives it three ways: neutral towards prices, the rate that would emerge from lending in kind, and the current value of the real return of actual business.Why is the process called cumulative?
- Because the gap widens automatically each year
- Because prices keep moving in the same direction for as long as the gap persists, rather than settling at a new level
- Because interest compounds
Show the answer
Answer: B.
The surplus over normal return accrues continuously while the rates stay apart, so firms keep expanding and prices keep rising.Why does Wicksell think exact coincidence of the two rates is unlikely?
- Because banks do not want it
- The natural rate moves continuously with the whole economic position, while the money rate is changed in discrete steps
- Because the natural rate is always higher
Show the answer
Answer: B.
He lists efficiency of production, the stock of capital and the supply of labour and land among the things that move the natural rate, and notes it fluctuates constantly.Sources
- Wicksell, Interest and Prices, translated by Kahn from the German Geldzins und Guterpreise of 1898 and published in English in 1936, chapter 8, on the rate of interest neutral to commodity prices, the definition of the natural rate on capital as the rate that would rule if lending were in kind, the surplus profit that accrues while the rates diverge, and the continuous movement of the natural rate against the discontinuous money rate.
- Wicksell, Interest and Prices, 1936, author's preface, where he states that the causative factor is the loan rate compared with the natural rate rather than the loan rate on its own.
What this leaves out
- This is a heterodox tradition. The mainstream account of the same phenomenon differs, and nothing here is a forecast or a view on any security.
- The rates in the figure and the example are round invented numbers chosen to show the three cases. They are not measurements of any period.
- Wicksell was not an Austrian economist, and this account of his distinction is the one this track builds on rather than the only reading of him. Whether a single natural rate exists is contested, and that is the next lesson.