Gibson’s paradox

The Gibson paradox is the positive correlation between the long-run rate of interest and the price level. As observed by Tooke (1838, 1844), who by this time had become the main representative of the Banking School in opposition to the Currency School in the nineteenth century in England, "[a] higher rate of interest, in consequence of the absorption by the war loans of a considerable proportion of the savings of individu- als; such higher rate of interest constituting an increased cost of production" (Tooke, 1838, p. 347).

Wicksell (1898 [1985], p. 69) emphasized the relevance of Tooke as an economist "equipped with an infinite amount of practical experience and unhampered by any very great theoretical ballast". After Tooke, only Wicksell realized the positive impact of lasting changes in the rate of interest on money and prices. His explanation, based on the marginalist theory of prices and distribution, is grounded in the variation of a non-observable natural rate of interest as a guide of money rates of interest. Obviously, the above-mentioned variation is inferred from the change in the money rate of interest, which is clearly observable.

According to this view, the natural rate of interest is set by real capital supply and demand, whereas the actual money rate of interest, lately adapted by the central bank, follows the natural rate of interest with a delay. Changes in prices are induced by the dif- ference between both rates of interest: if the natural rate of interest is higher (lower) than the money rate of interest, price variation will be positive (negative). In this way, lasting changes in the money rate of interest can be observed as part of the normal price of production of a commodity (Wicksell, 1898 [1985], p. 85).

Later, Keynes (1930, p. 198) called this relationship "Gibson's paradox" because, according to the marginalist theory, the correlation between interest rates and prices is negative: the higher the interest rate, the lower the level of investment, therefore a minor investment level would imply a lower pressure on prices. Keynes (ibid., p. 198) added that "it is one of the most completely established empirical facts within the whole field of quantitative economics though theoretical economists have mostly ignored it".

In fact, based on Gibson's (1923, 1926) notes, Keynes (1930, pp. 198-288) seemed to change his mind about the sign of the correlation between interest rates and prices, but his interpretation of the Gibson paradox remained within the marginalist mainstream, which considers that prices go up when the money rate of interest is below the natural rate of interest, inducing an increase in the former rate.

Gibson's notes suggested that the gold standard had little to do with generating this positive correlation, as put forward by Barsky and Summers (1988). Indeed, Keynes (1930, p. 199) himself showed that during a 137-year period the gold standard was sus- pended for 32 years (from 1797 to 1821, and after 1914) but nothing seemed to disrupt the continuity of the positive correlation between interest rates and the price level.

More recently, Pivetti's (1991) classical interpretation of Tooke's view - within the Sraffa framework - restores Tooke's original position, taking as given the techniques of production and the money interest rate (and not the techniques of production and the wage rate). According to Pivetti (1998, p. 43), "there is nothing 'paradoxical' in the positive correlation between interest [rates] and the price level".

The logic of that correlation is a cost-push channel of monetary policy, where the rate of interest plays a role in the cost of opportunity for firms to invest and it affects their cost of production and pricing decisions.

Many empirical models have been proposed to understand the impact of interest rates on marginal costs. For instance, Klein (1995) showed supporting evidence for US data; Barth and Ramey (2001) provided the same evidence using US data for 1960-96, showing that after a restrictive monetary policy shock, the price-wage ratio increases. In a similar vein, Hanson (2004) finds evidence of a price puzzle from 1959 to 1979.

Other denominations of Gibson's paradox are "the Cavallo-Patman effect" (Taylor, 1991) and "the price puzzle" (Eichenbaum, 1992).

See also:

Banking and Currency Schools; Natural rate of interest; Wicksell, Knut.