The Influence of the Rate of Interest on Prices 
Economic Journal XVII (1907), pp. 213-220. 
read before the Economic Section of the British Association,
1906. 
by Knut Wicksell 


    The thesis which I humbly submit to criticism is this. If,
other things remaining the same, the leading banks of the world
were to lower their rate of interest, say 1 per cent below its
ordinary level, and keep it so for some years, then the prices of
all commodities would rise and rise and rise without any limit
whatever; on the contrary, if the leading banks were to raise
their rate of interest, say 1 per cent above its normal level,
and keep it so for some years, then all prices would fall and
fall and fall without any limit except Zero. 
    Now this proposition cannot be proved directly by experience,
because the fact required in its hypothesis never happens. 
    The supposition was that the banks were to lower or raise
their interest, other things remaining the same, but that, of
course, the banks never do; why, indeed, should they? Other
things remaining the same, the bank-rate is sure to remain the
same too, or if, by any chance, e.g., by mistake, it were
altered, it would very soon come round to its proper level. My
thesis is, therefore, only an abstract statement, and somebody,
perhaps, will ask: what is the use of it then? But I venture to
assert that it may be of very great use all the same. Everybody
knows the statement of Newton that, if the attraction of the sun
were suddenly to cease, then the planets would leave their orbits
in the tangential direction; this, too, of course, is only an
abstract proposition, because the solar attraction never ceases,
but it is most useful nevertheless; indeed, it is the very
corner-stone of celestial mechanics; and in the same way I
believe that the thesis here propounded, if proved to be true,
will turn out to be the corner-stone of the mechanics of prices,
or rather one of its corner-stones, the influence of the supply
of precious. metals and of the demand for commodities from the
gold-producing countries being the other. 
    Before going further, however, we must answer one more
question. Our supposition might be not only unreal as to facts,
but even logically impossible; and then, of course, its use would
be nil. According to the general opinion among economists the
interest on money is regulated in the long run by the profit on
capital, which in its turn is determined by the productivity and
relative abundance of real capital, or, in the terms of modern
political economy, by its marginal productivity. This remaining
the same, as, indeed, by our supposition it is meant to do, would
it be at all possible for the banks to keep the rate of interest
either higher or lower than its normal level, prescribed by the
simultaneous state of the average profit on capital? 
    This question deserves very careful consideration, and, in
fact, its proper analysis will take us a long way towards solving
the whole problem. 
    Interest on money and profit on capital are not the same
thing, nor are they immediately connected with each other; if
they were, they could not differ at all, or could only differ a
certain amount at every time. There is no doubt some connecting
link between them, but the proper nature and extent of this
connection is not so very easy to define. 
    If we look only at credit transactions between individuals,
without any interference of banks, the connection between
interest and profit indeed seems obvious. If by investing your
capital in some industrial enterprise you can get, after due
allowance for risk, a profit of say, 10 per cent, then, of
course, you will not lend it at a much cheaper rate; and if the
borrower has no recourse but to individuals in the same situation
as you, he will not be able to get the money much cheaper than
that. 
    But it is a very different thing with the modern forms of
credit, which almost always imply the mediation of some bank or
professional money-lender. The banks in their lending business
are not only not limited by their own capital; they are not, at
least not immediately, limited by any capital whatever; by
concentrating in their hands almost all payments, they themselves
create the money required, or, what is the same thing, they
accelerate ad libitum the rapidity of the circulation of money.
The sum borrowed today in order to buy commodities is placed by
the seller of the goods on his account at the same bank or some
other bank, and can be lent the very next day to some other
person with the same effect. As the German author, Emil Struck,
justly says in his well-known sketch of the English money market:
in our days demand and supply of money have become about the same
thing, the demand to a large extent creating its own supply. 
    In a pure system of credit, where all payments were made by
transference in the bank-books, the banks would be able to grant
at any moment any amount of loans at any, however diminutive,
rate of interest. 
    But then, what becomes of the connecting link between
interest and profit? In my opinion there is no such link, except
precisely the effect on prices, which would be caused by their
difference. 
    When interest is low in proportion to the existing rate of
profit, and if, as I take it, the prices thereby rise, then, of
course, trade will require more sovereigns and bank-notes, and
therefore the sums lent will not all come back to the bank, but
part of them will remain in the boxes and purses of the public;
in consequence, the bank reserves will melt away while the amount
of their liabilities very likely has increased, which will force
them to raise their rate of interest. 
    The reverse of all this, of course, will take place when the
rate of interest has accidentally become too high in proportion
to the average profit on capital. So far, you will easily remark,
my proposition is quite in accordance with well-known facts of
the money market. If it be not true, if, on the contrary, as
Thomas Tooke asserted, and even Ricardo in his earlier writings
seems to have believed, a low rate of interest, by cheapening, as
they put it, one of the elements of production, would lower
prices, and a high rate of interest raise them -- a most specious
argument, resting, however, on the unwarrantable assumption that
the remuneration of the other factors of production could, under
such circumstances, remain the same -- then the policy of banks
must be the very reverse of what it really is; they would lower
their rates when prices were getting high and reserves becoming
low, they would raise them in the opposite case. 
    A more direct proof of my thesis is required, however, and
might be given in some such way as this. If as a merchant I have
sold my goods to the amount of £100 against a bill or promissory
note of three months, and I get it discounted at once by a bank
or a bill broker, the rate of discount being 4 per cent per
annum, then in fact I have received a cash price for my goods
amounting to £99. If, however, the hill is taken by the bank at 3
per cent, then the cash price of my goods has ipso facto risen,
if only a quartet of 1 per cent; very likely not even that,
because competition probably will force me to cede part of my
extra profit to the buyer of the goods. In other cases, however,
when long-term credit comes into play, the immediate rise of
prices might be very much greater than that. If the rate of
discount remains low, the interest on long loans is sure to go
down too; building companies and railway companies will he able
to raise money, say at 4 per cent instead of 5 per cent, and
therefore, other things being the same, they can offer, and by
competition will be more or less compelled to offer for wages and
materials, anything up to 25 per cent more than before, 4 per
cent on £125 being the same as 5 per cent on £100. 
    But, further -- and this is the essential point to which I
would call your special attention -- the upward movement of
prices, whether great or small in the first instance, can never
cease so long as the rate of interest is kept lower than its
normal rate, i.e., the rate consistent with the then existing
marginal productivity of real capital. When all commodities have
risen in price, a new level of prices has formed itself which in
its turn will serve as basis for all calculations for the future,
and all contracts. Therefore, if the bank-rate now goes up to its
normal height, the level of prices will not go down; it will
simply remain where it is, there being no forces in action which
could press it down; and consequently if the bank-rate remains
lower than its normal height, a new impetus towards forcing up
the prices will follow, and so on. The opposite of all this will
take place when the rate of interest has become too high in
proportion to average profit, and so in both cases a difference
between the two rates remaining, the movement of prices can never
cease, just as the electric current never ceases as long as the
difference of tension between the poles remains. 
    The proposition that a low rate of interest will raise
prices, a high rate of interest lower prices, is in some respects
anything but new; it has been stated more than once, but a
formidable objection was always triumphantly brought against it
in the shape of statistical facts; indeed, if you consider the
figures given, e.g., by Sauerbeck in his well-known tables in the
Journal of the Statistical Society, you will generally find that
high prices do not correspond with a low rate of interest, and
9ice 9ersa; it rather comes the opposite way, interest and prices
very often rising and falling together. But this objection quite
loses its importance; nay, more, it turns into a positive support
of our theory, as soon as we fix our eyes on the relativity of
the conception of interest on money, its necessary connection
with profit on capital. The rate of interest is never high or low
in itself, but only in relation to the profit which people can
make with the money in their hands, and this, of course, varies.
In good times, when trade is brisk, the rate of profit is high,
and, what is of great consequence, is generally expected to
remain high; in periods of depression it is low, and expected to
remain low. The rate of interest on money follows, no doubt, the
same course, but not at once, not of itself; it is, as it were,
dragged after the rate of profit by the movement of prices and
the consequent changes in the state of bank reserve, caused by
the difference between the two rates. In the meantime this
difference acts on prices in just the same way as would be the
case if, according to our original supposition, profit on capital
were to remain constant, and interest on money were to rise or
fall spontaneously. In one word, the interest on money is, in
reality, very often low when it seems to be high, and high when
it seems to be low. This I believe to be the proper answer to the
objection stated above, as far as the influence of credit on
prices is regarded; occasionally, of course, as in times of wild
speculation or panics, the problem is complicated very much by
the action of other factors, which need not here be taken into
consideration. 
    Granted, then, our theory to be true in the main or in the
abstract, what will be its practical consequences? to what extent
would the leading money institutions be able to regulate prices? 
    A single bank, of course, has no such power whatever; indeed,
it cannot put its rates, whether much higher or much lower than
prescribed by the state of the market; if it did, it would in the
former case lose all profitable business; in the latter case its
speedy insolvency would be the inevitable consequence. 
    Not even all the banks of a single country united could do it
in the long run; a too high or too low rate would influence its
balance of trade, and thereby cause an influx or reflux of gold
in the well-known way, so as to force the banks to apply their
rates to the state of the universal money market. 
    But supposing, as, indeed, we have done, that all the leading
banks of the commercial world were to follow the same course,
then gold could have no reason to go to one place more than to
another, and so the action exercised on prices would have its
sway without any hindrance from the international movement of
money. Still, even then it would, under the present
circumstances, have its obvious limits. As I remarked at the
outset, the influence of credit or the rate of interest is only
one of the factors acting on prices; the other is the volume of
metallic money itself, especially, in our times, the supply of
gold, and so long as the gold itself remains the standard of
value, this factor evidently will take the lead in the long run.
Were the production of gold materially to diminish while the
demand for money be unaltered, the banks no doubt, by lowering
their rate of interest, might for a while profitably react
against the otherwise inevitable pressure on prices, but only for
a while, because, even if the rather unnecessary stiffness of
present hank legislations could be slackened, the evergrowing
demand for gold for industrial purposes would gradually reduce
the bank stores, and could only be checked by raising the price
of gold -- that is, by lowering the average money prices. 
    The other extreme, which at present seems much more likely to
occur: a plethora of gold supply, and the rise of prices thereby
caused, could not be effectually met in any way, so long as free
coinage of gold exists.(1*)
    On the other hand, if this most essential step on the way to
a rational monetary system should be taken, if the free coining
of gold, like that of silver, should cease, and eventually the
banknote itself, or rather the unit in which the accounts of
banks are kept, should become the standard of value, then, and
not till then, the problem of keeping the value of money steady,
the average level of money prices at a constant height, which
evidently is to be regarded as the fundamental problem of
monetary science, would be solvable theoretically and practically
to any extent. And the means of solving it need not be sought in
some more or less fantastic scheme like that of a central issuing
bank for all the world, as it is sometimes proposed, but simply
in a proper manipulation of general bank-rates, lowering them
when prices are getting low, and raising them when prices are
getting high. 
    Nor would this system be at all artificial, because the point
about which the rate of interest would then oscillate, and to
which it would constantly gravitate, would be precisely what I
have called above its normal level, that one prescribed by the
simultaneous state of the marginal prOductivity of real capital,
the alterations of which we, of course, cannot control, but only
have to comply with. 

    P.S. -- When this paper was read at the British Association
meeting it was objected by Mr. Palgrave that the banks could not
possibly be charged with the regulation of prices, their liberty
of action -- if I understood him right -- being, in his view,
restricted by the necessity of protecting their own reserves as
well from getting too low in consequence of an unfavorable
balance of trade, as from running to an unprofitable height by an
influx of gold. This, no doubt, is true, but it must not be
forgotten that the international rate policy of banks has, as it
were, two degrees of freedom, in so far as the international
movement of gold can be checked or modified, not only by raising
the rate of discount in the country from which the metal flows,
but also by lowering it in the country, or countries, to which
gold is flowing. In other words, the action of the banks against
each other, which has for its object the proper distribution of
money, or the levelling of the niveau of prices between different
countries, might logically be concomitant with a common action
for the purpose of keeping the universal value of money and level
of prices at a constant height, which, however, under present
circumstances only can be done within the limits prescribed by
the general supply of gold. 
    On the other hand, it was remarked by Professor Edgeworth
that if the free coinage of gold be suppressed, the Governments
themselves have in their hand the regulating of general prices.
This, too, is true, at any rate so long as the present large
production of gold persists; and even if it should cease, and
gold become scarce, the Governments, no doubt, might supplant the
lack in currency by a judicious emission of paper-money. But a
single Government has in this respect only the choice between two
alternatives; it may try to keep the value of its money steady
towards the commodities, but then it necessarily sacrifices the
parity of its exchanges; or else it may manage to keep its
exchanges strictly at par, but then it has of itself no power
over the level of prices. Some international agreement, either
regarding the amount of gold to he coined by each country or else
involving a common rate-policy of the banks as described above,
must needs come into play, shall both those purposes -- the
steadiness of the average value of money and the parity of
exchanges -- be fulfilled together; and it seems to me, although
I may he mistaken, that for several reasons such agreements could
he far more easily and effectually made by the banks, with the
support, that is, of the Governments, than by the Governments
themselves exclusive of the banks. 
    For a more detailed analysis of the practical side of the
question and of the whole argument, I must refer to my book,
Geldzins und Guterpreise (Jena: Gustav Fischer, 1898; being the
further development of an article in Conrad's Jahrbucher, Bd. 13,
1897), as well as to my printed University Lectures (Bd. I: 2,
1906, in Swedish).


NOTES:

1. It is not easy to describe or imagine the exact manner in
which an excess or deficiency in the ordinary gold supply affects
prices, although its ultimate effect on them cannot well be
doubted. As in our days the new gold generally finds its way as
soon as possible to the banks, the common impression seems to be
that it by so much increases the loanable funds of the banks, and
therefore in the first instance causes the rate of interest to go
down. This, no doubt, would be true if the new gold in its
totality were deposited by its owners as capital for lending
purposes, and in so far as this may be the case it indeed affords
an illustration, and the only practical one, of the lowering of
bank rates effecting a rise of prices. But mostly, I suppose, the
gold comes to us not as lending capital, but as payment for the
imports of the gold-producing countries, and if so its acting on
the prices will be much more immediate and its effect on the rate
of interest very slight. It is even possible that the rise of
prices, caused by the increased demand for commodities from the
gold countries, will forerun the arriving of the gold, the
necessary medium of exchange being in the meantime supplied by an
extension of the credit, so that the rate of interest perhaps
will rise from the beginning. In any case the ultimate effect an
increased gold supply will be a rise, not a fall, in the rate of
interest (and of vice versa with a lacking supply of gold),
because the large mining enterprises and the buying up of gold by
the non-producing counties have actually destroyed large amounts
of real capital and thereby given the rate of profit a tendency
to rise. This all may be the explanation of some rather
perplexing features in economic history, a rise of prices even
when apparently caused by a surplus of gold supply very seldom
being accompanied by a low rate of interest, but generally by a
high one.