§1. Price Changes and Interest Rates

No problem in economics has been more hotly debated than that of the various relations of price levels to interest rates. These problems are of such vital importance that I have gone to much trouble and expense to have such data as could be found compiled, compared, and analyzed. The principal result of these comparisons are given in this chapter.

The general theory of the relationship between the rate of interest and the buying power of money was summarized in Chapter II. The main object of this chapter is to ascertain to what extent, if at all, a change in the general price level actually affects the market rates of interest.

Since the theory of Chapter II presupposes foresight, the question arises at the outset: How is it possible for a borrower or lender to foresee variations in the general price level with the resultant increase or decrease in the buying power of his money? A change in the value of money is hard to determine. Few business men have any clear ideas about it. If we ask a merchant whether or not he takes account of appreciation or depreciation of money values, he will say he never heard of it, that "a dollar is a dollar!" In his mind, other things may change in terms of money, but money itself does not change. Most people Edition: current; Page: [400] are subject to what may be called "the money illusion," and think instinctively of money as constant and incapable of appreciation or depreciation. Yet it may be true that they do take account, to some extent at least, even if unconsciously, of a change in the buying power of money, under guise of a change in the level of prices in general. If the price level falls in such a way that they may expect for themselves a shrinking margin of profit, they will be cautious about borrowing unless interest falls, and this very unwillingness to borrow, lessening the demand in the money market, will tend to bring interest down. On the other hand, if inflation is going on, they will scent rising prices ahead and so rising money profits, and will be stimulated to borrow unless the rate of interest rises enough to discourage them, and their willingness to borrow will itself tend to raise interest.

And today especially, foresight is clearer and more prevalent than ever before. The business man makes a definite effort to look ahead not only as to his own particular business but as to general business conditions, including the trend of prices.

Evidence that an expected change in the price level does have an effect on the money rate of interest may be obtained from several sources. During the free-silver agitation of 1895 and 1896, municipalities could sell gold bonds on better terms than currency bonds. There was a strong desire on the part of lenders to insert a gold clause in their contracts, and to secure it they were willing to yield something in the interest rate.

The same tendency was strikingly shown in California during the inflation period of the Civil War.43 For a time, Edition: current; Page: [401] gold contracts could not be enforced, and in consequence interest rates were exceptionally high.