§10. Relations of Prices and Interest Interpreted

The studies of P,P' and in relation to i have brought out four relationships:

(1) The rate of interest tends generally to be high during a rising price level and low during a falling price level;

(2) The rate of interest lags behind P' so that often the relationship is obscured when direct comparison is made;

(3) The rate of interest correlates very markedly with , representing the distributed effect of lag. For recent years in Great Britain, the close relationship is indicated by r = +0.98 when i is lagged and the effects of P' are distributed over 28 years;

(4) The rate of interest tends definitely to be high with a high price level and low with a low price level.

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We have also seen that the first three sets of facts fit in with the analysis presented, the first corresponding, although only roughly, with the ideal assumption of perfect foresight and adjustment, the second and third corresponding to the more realistic assumption of imperfect foresight and delayed, but accumulated, adjustment.

Two facts have, I think, now been well established. The first, that price changes influence the volume of trade, has been shown in earlier studies made by me.61 The second, that the volume of trade influences the rate of interest, has been shown by Carl Snyder,62 Col. Leonard Ayres,63 Prof. Waldo F. Mitchell,64 and others.

The evidence for both relationships is not only empirical but rational. Rising prices increase profits both actual and prospective, and so the profit taker expands his business. His expanding or rising income stream requires financing and increases the demand for loans.

In my study of the so-called business cycle, the lag of volume of trade, T, behind price changes when the influence of P' was distributed over a range of 25 months, was found to have a modal value of 9½ months. The Edition: current; Page: [440] lag of i behind T using a simple lag was found by Carl Snyder to be 10 to 15 months, by Leonard Ayres to be about 14 months and by Waldo F. Mitchell about 6½ months.

If we add the lag of T behind P' which I found to be over all about 25 months, and the lag of i behind T of 14 months, found by Snyder and Ayres, we obtain a combined lag of i behind P' of 39 months. This combined lag obtained by simple addition is far shorter than the lags discovered in the calculations presented above, whether for yearly or for quarterly price changes in relation to i. Apparently the double distribution of the lag of T behind P' and again of i behind T may result in a greater lag than would be obtained by simple addition.

The fourth relationship stated above must be, I think, regarded as an accidental consequence of the other three. At any rate, it seems impossible to interpret it as representing an independent relationship with any rational theoretical basis. It certainly stands to reason that in the long run a high level of prices due to previous monetary and credit inflation ought not to be associated with any higher rate of interest than the low level before the inflation took place. It is inconceivable that, for instance, the rate of interest in France and Italy should tend to be permanently higher because of the depreciation of the franc and the lira, or that a billion-fold inflation as in Germany or Russia would, after stabilization, permanently elevate interest accordingly. This would be as absurd as it would be to suppose that the rate of interest in the United States would be put on a higher level if we were to call a cent a dollar and thereby raise the price level a hundredfold. The price level as such can evidently have no permanent influence on the rate of interest except Edition: current; Page: [441] as a matter of transition from one level or plateau to another.

The transition from one price level to another may and does work havoc as we have seen, and the havoc follows with a lag which is widely distributed. The result is that during a period of inflation the interest rate is raised cumulatively, so that at the end of this period when the price level is high, the interest rate is also high. It would doubtless in time revert to normal if the new high level were maintained, but this seldom happens. Usually prices reach a peak and then fall. During this fall the interest rate is subject to a cumulative downward pressure so that it becomes subnormal at or near the end of the fall of prices. Thus, at the peak of prices, interest is high, not because the price level is high, but because it has been rising and, at the valley of prices, interest is low, not because the price level is low, but because it has been falling.

Another consideration seems to complete the explanation of the close association between high and low price levels with high and low interest respectively. This is the necessity for banks to cope with maladjustments following inflation and deflation. Mr. R. G. Hawtrey has emphasized this point in a letter to me, and I have summarized his views almost in his own words:

When credit is expanding, the rising price level and high profits bring about a high rate of interest. When the expansion has reached, the limit permitted by the stock of gold, the rate of interest is put still higher in order to bring about a fall in the price level. When the fall in prices takes effect, a low rate of interest becomes appropriate, and when credit contraction has proceeded so far that a redundant supply of gold has accumulated, the rate of interest is depressed still lower in order to bring about a renewed rise in the price level. Thus a high rate of interest corresponds first with rising, Edition: current; Page: [442] then with falling, prices, and so synchronizes with high prices. A low rate of interest corresponds first with falling, and then with rising, prices, and so synchronizes with low prices.

The process of inflation boosts both prices and interest, until a still further boost of interest is made by the banks in order to stop the over extension, leaves a peak of prices with high interest before, at, and after that peak, while, contrariwise, the process of deflation reduces both prices and interest until a still further reduction of interest is made by the banks in order to stop the depression, leaves a valley of prices with low interest before, at, and after the valley.

Such considerations seem to be sufficient to explain the otherwise puzzling and apparently irrational coincidence which we have so often found to exist between high and low prices and high and low interest rates.

The only alternative interpretation of which I can think is that a high or low price level is not a monetary and nominal affair but a matter of real commodities. Sometimes, as in France and Italy just cited, the high prices may be closely associated with impoverishment. If it were true that a high price level usually signified a real scarcity of goods—a low income stream—while a low price level usually signified relative abundance, we could explain our puzzle by the relation of time preference to the size of the income stream. But the facts in general do not seem to justify such an interpretation,65 least of all in the United States in the War years when the correlations are the highest. During that period, incomes increased at a tremendous rate, and interest rates advanced pari passu.

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