Posted by: Dirk | August 13, 2007

(Book review) Interest and prices

Knut Wicksell can be considered as one of the founding fathers of macroeconomics. His 1898 book Geldzins und Güterpreise runs along lines very typical for this field. What role for interest rates and prices in an economy? Wicksell departs from quantity theory, which he amends by the natural rate of interest. The natural rate of interest is the real rate of return to capital. A entrepreneur using 100 units of capital to produce 105 units of capital (after deduction of all costs) has a real rate of return to capital of 5 per cent. In case that he owns no capital he has to borrow from banks at 5 per cent maximum. Otherwise he would operate at a loss. According to Wicksell prices change when the rate of interest charged by banks deviates from the natural rate. This is set to happen since the natural rate oscillates, influenced by technical progress and other things.

If the rate of interest charged by the banks is below the natural rate, then entrepreneurs earn windfall profits and expand their production. Given that the quantity of inputs does not change, this will drive up prices. Households need more money to buy goods, demand for money rises. Given that the supply of money is stable, this will pull the interest rate up. This process goes on until both rates are identical again. Before Wicksell sketches out his theory, he sums up very nicely what money is, why banks are useful as immediators and what price changes mean. This is a very good preparation for the theory to come. Wicksell’s book can be recommended to anyone interested in macroeconomics.

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