Knut Wicksell Interest and Prices

Knut Wicksell, Interest and Prices

This brings us to his famous theory as to the relation of interest to prices, and the "cumulative process."

The central point in this theory is the doctrine that there is a "natural" rate of interest, and a bank rate or money rate which will be here called the market rate; and that the relation between these two rates is of great importance. The "natural" rate is one that equalizes saving and investment. It tends to equal the expected yield on newly created capital goods. It is virtually Bohm-Bawerk's marginal productivity of capital. It is relatively stable. The market rate on money loans or credit is merely the price of money determined according to the Walras formula in combination with other scarce goods in a single system of simultaneous equations. It tends to equal the "natural" rate, but may be above or below it.

If the market rate be relatively low, (1) saving is discouraged, (2) consumption tends to rise, and enterprisers tend to see profit opportunities, (3) investment is stimulated, (4) prices rise. If, however, the market rate be above the natural rate, enter­prisers lose, business declines, and prices fall. These conditions often appear in reality, and unless one be alert to consider that they may be results of a common cause, they may suggest that by manipulating the market rate, one can control price levels. Hesitatingly, and while still defending the quantity theory, Wicksell adopts this suggestion, saying that the market rate may be kept below the natural rate, and prices be kept rising, as long as the supply of loanable funds is supplemented by creating credit, or by dishoarding.