By Dr Frank Shostak
Most commentators are of the view that what prevents the attainment of price stability is the deviation of the policy interest rate such as the federal funds rate from the neutral interest rate also known as the natural interest rate. The natural interest rate, it is held, is the one that is consistent with stable prices and a balanced economy. What is required then is that Fed policy makers successfully direct the federal funds rate towards the natural interest rate.
It is held that once the Fed brings the federal funds rate in line with the natural interest rate, price stability and economic stability are likely to emerge. This way of thinking is based on the writings of the Swedish economist Knut Wicksell in the late 19th century. Note that the current framework of central banks operations throughout the world is based to a large degree on the writings of Wicksell.
Knut Wicksell’s framework for price stability
The key of the Wicksell’s framework is the natural interest rate, which Wicksell defined as,
A certain rate of interest on loans which is neutral in respect to commodity prices, and tend neither to raise nor to lower them. This is necessarily the same as the rate of interest which would be determined by supply and demand if no use were made of money and all lending were effected in the form of real capital goods. It comes to much the same thing to describe it as the current value of the natural rate of interest on capital.
Hence, according to Wicksell the natural interest rate is the rate at which the demand for physical loan capital coincides with the supply of savings expressed in physical magnitudes.
In Wicksell’s framework, if the market interest rate falls below the natural interest rate, investment is going to exceed savings implying that the quantity of goods demanded is going to be greater than the quantity of goods supplied. Wicksell assumed that the excess in the quantity of goods demanded is likely to trigger an increase in bank loans and an increase in the stock of money. Consequently, the prices of goods are going to increase.
Conversely, if the market interest rate rises above the natural interest rate, savings are going to exceed investment, the quantity of goods supplied is going to outstrip the quantity of goods demanded, bank loans and the stock of money are going to contract, and the prices of goods are going to fall.
Hence whenever the market interest rate corresponds to the natural interest rate the economy is in a state of equilibrium and there are neither upward nor downward pressures on the price level. Again, the deviations of the market interest rate from the natural interest rate sets in motion changes in money supply and this in turn disturbs the general price level.
Wicksell held that to establish whether monetary policy is tight or loose it is not enough to pay attention to the level of the market interest rate, but one should compare the market interest rate to the natural interest rate. If the market interest rate is above the natural interest rate, then the policy stance is tight. Conversely, if the market interest rate is below the natural interest rate, then the policy stance is loose.
How is one to implement this framework of thinking? The main problem here is that the natural interest rate cannot be observed. How can one tell whether the market interest rate is above or below the natural interest rate?
Wicksell suggested that policy makers should pay close attention to changes in the price level. A strengthening in the growth rate of prices would call for an upward adjustment in the market interest rate, whilst a weakening in the growth rate of prices would signal that the market interest rate should be lowered.
Real interest rate cannot be ascertained
Would it be possible in a world without money, such as presented by Wicksell, to establish the interest rate on the lending of present apples in return for potatoes in the future?
In a world without money, all that one could establish is the quantity of present goods exchanged for the quantity of various future goods. For instance, one present apple is exchanged for two potatoes in a one-year time. Alternatively, one present shirt is exchanged for three tomatoes in a one-year time. There is, however, no way to establish the interest rate that a lender of an apple receives from a borrower of this apple that repays the loan by means of potatoes.
It is not possible to calculate the interest rate on the loan since potatoes and apples are not the same goods. Only in the framework of the existence of money can the interest rate be established. The following example provides an illustration of the interest rate formation.
John the baker who produced the ten loaves of bread sells these loaves for ten dollars. Now, according to his time preference John is ready to become a lender of the ten dollars in return for eleven dollars in a one-year time. Note that John the baker assigns a greater importance to the future eleven dollars versus the present ten dollars otherwise he would not agree to become a lender of the ten present dollars.
According to the time preference of Bob the shoemaker, he is willing to borrow the ten dollars and repay eleven dollars in one-year time. The shoemaker assigns a greater importance of having the ten dollars in the present versus the eleven dollars in a one-year time. Hence, both John the lender and Bob the borrower are likely to agree to enter this financial transaction because they are both expecting to benefit from it.
Note that the baker has exchanged the ten loaves of bread for money first i.e. the ten dollars. He then lends the ten-dollars for the eleven dollars in one-year time. Again, the interest rate that he secures for himself is ten percent. As far as the shoemaker is concerned, he pays the ten percent interest rate to the baker.
Note that without the existence of money, the baker could not establish the quantity of future goods required by him that is going to equate with the interest rate of ten percent. Only by means of money, the market interest rate could be established. Given that in the world without money the interest rate cannot be established it follows that the natural interest rate cannot be established either. Please note that according to Wicksell the natural interest rate is established in the world without money.
Additionally, note that according to Wicksell the natural rate is established as the rate at which the total demand for physical capital coincides with the total supply of physical capital. However, the total physical demand and supply of capital cannot be established since capital goods are heterogeneous and cannot be added to a meaningful total.
Consequently, it is not possible to separate the natural interest rate from the market interest rate. We can thus conclude that economists’ and central bankers’ attempts to establish the natural interest rate should be regarded as an impossible task. We suggest that in a free market, without the central bank, no one would be required to establish whether the market interest rate is above or below the natural interest rate.
Conclusion
The essence of Fed’s policy makers thinking emanates from the ideas of the late 19th century writings of the Swedish economist Knut Wicksell. According to Wicksell, the key to economic stability is targeting the market interest rate to the natural interest rate. It is however, not possible to isolate the natural interest rate. Consequently, policies that are aiming at reaching an unknown interest rate run the risk of promoting more rather than less instability.
