In this article we will discuss about the natural and market rate of interest.
The Wicksell Theory on Natural and Market Rate of Interest:
Knut Wicksell was the first economist to discuss in detail the relation between natural interest rate and market interest rate. In his book Interest and Prices, he uses such phrases as ‘ordinary rate’, ‘the normal rate’, and ‘the real rate’ as synonyms for the natural rate.
He defined it in these words – “The rate of interest at which the demand for loan capital and the supply of savings exactly agree, and which more or less corresponds to the expected yield on the newly created capital, will then be the normal or natural real rate”.
It is the rate consistent with a stable money supply and stable prices. On the other hand, the market rate of interest is the money rate prevailing in the loan market. It is the rate of interest charged by banks or lenders. It depends upon the demand and supply of money.
The Wicksell theory is based on the following assumptions:
1. There is full employment in the economy.
2. Investment is a decreasing function of the rate of interest.
3. Saving is an increasing function of the rate of interest.
According to Wicksell, the natural rate is essentially variable. It is partly determined by the demand for loans which, in turn, depends on the expected profitability of new investment. All factors which affect the expected profitability of investment bring changes in the natural rate of interest.
They are changes in productive efficiency or technical progress, changes in domestic and foreign demand, changes in the supply of capital, labour and land, etc. But in order to ensure a constant supply of savings, which is the second determinant of the natural rate of interest, the natural rate would have to be the same in all enterprises and in all uses, with the ratio for future land to present land equal to the ratio of future labour to present labour. Any shift in these relationships would change the value of capital and alter the connection between capital goods industries and consumer goods industries.
Wicksell points out that the natural rate is not the same as the market rate. There are disparities between the two rates during the short run which produce changes in the price level. The market rate of interest tends to be sticky and responds slowly to changes in the demand for loanable funds. In the long run, disparities between the two rates automatically generate forces which bring their equality.
According to Wicksell, the natural rate diverges from the market rate when the economy is in disequilibrium. As a result, a cumulative process is created whereby discrepancy emerges between the cost of borrowing capital and expected profitability of new investment.
A cumulative process is a disequilibrium situation in which net investment is positive and is constantly increasing from period to period. This happens when the market rate is lower than the natural rate. This is shown in Figure 12 Where I is the investment demand curve or the demand curve for loans and S is the supply curve of savings or loanable funds. Suppose r is the natural rate of interest and r, the market rate of interest.
Thus at the market rate of interest r1 the investment demand (or demand for loans) exceeds the supply of savings by AB. It means that bank loans expand and funds are used to increase the demand for investment goods. As a result, the total demand for money exceeds the available supply of money. In a situation of full employment, this raises the demand for goods and services thereby increasing prices.
This increased demand for money, in turn, raises the market rate of interest. With the rise in the market rate of interest, money incomes expand and the transactions demand for money increases which reduces the available supply of money for lending purposes.
Assuming no further increase in money supply, the money rate of interest comes into equality with the natural rate of interest at point E in Figure12. On the contrary, if the money rate of interest is higher than the natural rate, the demand for bank loans falls, bringing down the market rate of interest till it equals the natural rate.
According to Wicksell, the cumulative process of disequilibrium may also be caused by increase in the demand for loans due to innovations and technical progress which raise the expected profitability of new investment. This is illustrated in Figure 13.
The initial monetary equilibrium is shown by the equality â€ž of S and I curves at point E where both the natural and market rates H are equal at r interest rate. The increased demand for loans is shown c by the shifting of the investment demand curve upward from I to I1 .
This causes the natural rate to rise to r1 when the S and I1 curves intersect at E1 If the monetary authority does not raise the market rate r to the level of the natural rate r1 the banks increase their lending’s at the market rate of interest (r). The increased monetary demand will raise prices.
As prices rise aggregate demand would increase along the horizontal axis at the market rate r. In terms of Figure 13, at the market rate r, the supply of loans by banks is OQ (=rE) and with the increase in the demand for investment funds to I], banks increase the money supply by QQ, (=EA).
Thus the horizontal line EA is a perfectly elastic supply curve which equals J, curve at A and the increased investment demand is met by QQ1 loans from the banks. With the increase in money supply, the demand for capital goods rises which, in turn, raises the demand for goods and services, and consequently raises their prices.
This process of money expansion and inflationary rise in prices will ultimately raise the market rate r to the level of natural rate of interest r1. In Wicksell’s analysis, business fluctuations are traced to the divergence between natural and market rates of interest. Expansion in the economy takes place when the natural rate is above the market rate, and vice-versa.
In the cumulative process of upward or downward change, expansions and contractions of bank credit play a crucial role. The cumulative process comes to an end when the two rates are brought into equality. But prices would not be restored to the original level, yet there would be a new equilibrium for the economy where the market rate equals the natural rate.
A Critical Appraisal:
Wicksell integrated interest theory, quantity theory, aggregate demand and aggregate supply, and the functioning of a modern banking system. He thus anticipated some of the current notions in monetary theory.
Wicksell stated three conditions in his theory:
First, the equality between the natural (equilibrium) rate and the market (bank) rate.
Second, the equality of ex ante saving and investment.
Third, a constant price level.
These identical conditions have come to be known as “monetary equilibrium” in modern monetary analysis. It was Wicksell who attributed changes in the price level to discrepancies between aggregate demand and aggregate supply on the basis of relationship between saving and investment. In this way, he formulated an income approach to the problem of money and prices which “contained the embryo of a theory of output as a whole”, according to Ohlin.
It was again Wicksell who stressed the importance of the rate of interest in monetary theory. “By concentrating upon the rate of interest”, writes Prof. Hansen, “He swept away the narrow foundations of the quantity theory.”
Further, Wicksell integrated monetary and non-monetary theories of interest by emphasizing the equilibrium of natural interest rate and market interest rate. He thus paved the way for a determinate theory of interest, as developed by Hicks and Hansen, which is regarded as the modern theory of interest.
Again, Wicksell’s cumulative process has come to be known as the Wicksell Effect. It emphasises the importance of bank credit-creation on the rate of interest. Mrs. Robinson regards the Wicksell Effect as “the key to the whole theory of capital accumulation.”
Moreover, Wicksell was a quantity theorist who wanted “to arrive at a theory which should be both self- consistent and in full agreement with facts.” His analysis of the link between the banking system and short-run inflations during the cumulative process is to be found in the hyper-inflation case studies in Friedman’s Studies in the Quantity Theory of Money. Similarly the suppressed inflation that followed the post-War years 1945-51 due to the policies adopted by monetary authorities in the USA may also be attributed to the Wicksellian cumulative process. Thus Wicksell was the forerunner of the modern monetary theorists.
But he is not free from critics who have pointed out certain defects in his theory.
1. According to Professor Ackley, “Wicksell’s analysis differed from the simple quantity theory only in the process by which its results were achieved, not in its results. In equilibrium, prices were proportional to the money supply, and both were constant in time. In equilibrium, there were no idle balances flowing into the capital market nor additions needing to be made to cash balances in order to finance a larger volume of money transactions.” Thus Wicksell thought of only transactions and precautionary matives neglected the speculative motive to hold money.
2. “Moreover, his work falls short of an adequate theory of income determination. It related to one determinant of income, the investment function,” according to Hansen.
3. Hansen further points out that “the multiplier analysis, based on the consumption function was missing. There is, moreover, implicit in much of Wicksell’s work an excessively optimistic view with respect to the interest-elasticity of investment. And he saw very dimly the relation of the demand for cash holdings to the rate of interest.
He failed to see that in certain situations the investment function may be interest-inelastic while the liquidity preference function may be highly interest-elastic. Wicksell did not clearly understand the conditions under which interest-rate policy becomes futile. Accordingly, he enormously exaggerated the power of the banking system to control, by interest rate manipulations, the flow of aggregate demand and the level of prices:”
Fisher’s Analysis on Natural and Market Rate of Interest:
In modern analysis, the real or natural rate of interest refers to the percentage rate paid on borrowed money after making on adjustment for changes in the price level. On the other hand, the market or money rate of interest is the percentage rate paid on borrowed money. If a person borrows Rs. 10,000 from a bank at 6 per cent, it is the money rate of interest.
He will have to return Rs. 10,600 (Rs. 10,000 + Rs. 600 as interest charges) to the bank after a year. If, however, during this period the price index rises by 1.02, the real rate of interest is reduced. In order to find out the real rate of interest, the sum repaid to the bank is deflated by the price index, i.e. Rs. 10,600/1.02=Rs. 10,392.
It implies that the bank has earned 3.92 per cent as real interest as against the money rate of 6 per cent per annum. If the price index falls, given money rate of interest will imply a higher real rate of interest.
Following Marshall, Fisher enunciated the proposition that the money rate of interest is equal to the real rate of interest plus the rate of change in the price level. Suppose prices are falling at 5 per cent per annum, a zero money rate of interest in this case implies a real rate of 5 per cent.
To quote Marshall, a money rate of 5 per cent per annum corresponds to a ml rate Of 15.5 per cent when prices are falling at 10 per cent per annum, i.e., the purchasing power of $ 105 at the beginning of the year is equivalent to that of $ 115.50 at the end of the year. Similarly, a money rate of 5 per cent corresponds to a negative real rate of 5.5 per cent when the annual rate at which prices are rising is 10 per cent.
In case the price level is constant, the money rate equals the real rate of interest. To take our previous example, let the money rate of interest and the real rate of interest be 6 per cent with a constant price level. Suppose with a rise in the price level by 2 per cent, the real rate of interest falls to 4 per cent equivalent to the rise in the price level.
There is, however, no change in the money rate due to “the money illusion or institutional rigidity in the money market.” Given the marginal efficiency of investment, a fall in the real rate of interest will encourage investment and vice-versa. This is illustrated in Fig 14. Money and real interest rate are taken on the vertical axis along with the marginal efficiency of investment.
The amount of investment is shown on the horizontal axis. MEI is the curve of marginal efficiency of investment. With a constant price level, mr represents money as well as real rate, of interest which is 6 per cent per annum. At this rate, OI investment is taking place. With the rise in the price level by 2 per cent, there is an equivalent fall in the real rate, as depicted by the new interest line r1 r2 at 4 per cent interest rate. Now the mr line represents only the money rate of 6 per cent. A fall in the real rate of interest has tended to encourage investment from OI to OI1 Converse is true when the price level falls.