Monday, September 27, 2021

Gibson's Paradox and Inflation

 Trending on Twitter. Mike Norman has been saying forever that raising the interest is a price increase and therefore it is an inflationary bias rather than a deflationary one as supposed. This is a chief factor affecting the price level, along with what the government chooses to pay in the market to transfer resources to public use. 

Conventional economists conclude that interest rates are inversely correlated with price level based on theoretical assumptions, but evidence shows the opposite. MMT economists point out that the theoretical assumptions of conventional economics are wrong in that they do not take institutional arrangements into account but rather assume that market forces operate freely to equilibrate supply and demand naturally based on rational maximization and that this leads to general equilibrium. The data say otherwise.

Gibson's Paradox is the observation that the rate of interest and the general level of prices are positively correlated.[1] It is named for British economist Arthur Herbert Gibson who noted the correlation in a 1923 article for Banker's Magazine. The correlation had been noted earlier by Thomas Tooke.[2]The term was first used by John Maynard Keynes, in his 1930 work, A Treatise on Money.[3] It was believed to be a paradox because most economic theorists predicted that the correlation would be negative. Keynes commented that the observed correlation was "one of the most completely established empirical facts in the whole field of quantitative economics."

The Quantity Theory of Money predicts that a slower money-growth creates slower price-rise. In addition, slower money-growth means slower growth of loanable funds and thus raises interest rates. If both these premises are true, slower money-growth should mean lower prices and higher interest rates. However, Gibson observed that lower prices were accompanied by a drop—rather than a rise—in interest rates. This is the paradox that needs to be explained. For instance, in the 1873-96 depression, prices fell considerably while interest rates remained low. Economist S.B. Saul says that Alfred Marshall explained the paradox by saying that other factors might have been at play: a peace dividend and improving international system of banking and finance.
Economists generally thought that interest rates were correlated to the rate of inflation, whereas Keynes' findings contradicted this view. During the period of gold standard, he concluded that interest rates were correlated to the general price level, and not the rate of change in the prices. In fact, he thought that interest rates were highly correlated to the wholesale price index rather than the rate of inflation.[4]
Gibson's Paradox