"The ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood. Indeed the world is ruled by little else. Practical men, who believe themselves to be quite exempt from any intellectual influence, are usually the slaves of some defunct economist."
–John M. Keynes1

It is held by many commentators that the Fed’s monetary policy, which is aimed at achieving price stability, is the key factor for attaining stable economic growth.

It is also held that what prevents the attainment of price stability is the fluctuations of the federal funds rate around the neutral interest rate, also known as the natural interest rate.

The natural interest rate, it is held, is one that is consistent with stable prices and a balanced economy. What is required, then, is that the Fed successfully steer the federal funds rate toward the natural interest rate.

It is held that once the Fed brings the federal funds rate in line with the natural interest rate, price stability and economic stability are likely to emerge.

Note that this framework has its origins in the eighteenth-century writings of the British economist Henry Thornton. The Swedish economist Knut Wicksell further articulated this framework of thinking in the late nineteenth century.2

In fact, it is safe to suggest that the current framework of central bank operations throughout the world is based to a large degree on Wicksellian writings.

Now, if what we are suggesting is valid, obviously, then, what is required to understand the rationale of central banks actions is the writings of Knut Wicksell.

Knut Wicksell’s Framework for Price Stability

The heart of Wicksell’s framework is the natural interest rate, which Wicksell defined as,

A certain rate of interest on loans which is neutral in respect to commodity prices, and tend neither to raise nor to lower them. This is necessarily the same as the rate of interest which would be determined by supply and demand if no use were made of money and all lending were effected in the form of real capital goods. It comes to much the same thing to describe it as the current value of the natural rate of interest on capital.3

Hence, according to Wicksell, the natural interest rate is the rate at which the demand for physical loan capital coincides with the supply of savings expressed in physical magnitudes.4

In his framework, Wicksell makes a clear distinction between the interest rate that is formed in the financial market and the interest rate that is established in the market without money. According to Wicksell the natural interest rate is formed by real factors without money.

On this Wicksell wrote,

Now if money is loaned at this same rate of interest, it serves as nothing more than a cloak to cover a procedure which, from the purely formal point of view, could have been carried on equally well without it. The conditions of economic equilibrium are fulfilled in precisely the same manner.5

In the Wicksellian framework, money only affects the price level. The effect of money on the price level is, however, not direct; it works via the gap between the market interest rate and the natural interest rate. If the market interest rate falls below the natural interest rate, investment is going to exceed savings, implying that the quantity of goods demanded is going to be greater than the quantity of goods supplied. Wicksell assumed that the excess in the quantity of goods demanded is financed by means of an expansion in bank loans.

This, according to Wicksell leads to the creation of new money, which in turn pushes the general level of prices higher. Conversely, if the market interest rate rises above the natural interest rate, saving is going to exceed investment, the quantity of goods supplied is going to outstrip the quantity of goods demanded, bank loans and the stock of money are going to contract, and prices are going to fall.6 Hence whenever the market interest rate corresponds to the natural interest rate the economy is in a state of equilibrium and there are neither upward nor downward pressures on the price level.

Again, deviations in the market interest rate from the natural interest rate set in motion changes in money supply, and this, in turn, disturbs the general price level.

According to Wicksell,

If it were possible to ascertain and specify the current value of the natural rate, it would be seen that any deviation of the actual money rate from this natural rate is connected with rising or falling prices according as the deviation is downward or upward.7

Wicksell held that since the supply of real capital is limited, whereas the supply of money is elastic, there is no reason to expect that the market interest rate is going to correspond to the natural interest rate.8 Hence, central authorities should steer the market interest rate toward the natural interest rate.

Furthermore, Wicksell maintained that to establish whether monetary policy is tight or loose, it is not enough to pay attention to the level of the market interest rate, but rather one needs to compare the market interest rate with the natural interest rate. If the market interest rate is above the natural interest rate, then the policy stance is tight. Conversely, if the market interest rate is below the natural interest rate, then the policy stance is loose.

How is one to implement this framework of thinking? The main problem here is that the natural interest rate cannot be observed. How can one tell whether the market interest rate is above or below the natural interest rate? Wicksell suggested that policymakers should pay close attention to changes in the price level. A strengthening in the growth rate of prices would call for an upward adjustment in the market interest rate, whilst a weakening in the growth rate of prices would signal that the market interest rate should be lowered.9

Note that this procedure is adopted by all central banks. If the growth rate in the consumer price index is above a target set by policymakers, then the central bank is likely to lift its policy interest rate. Conversely, when the consumer price index is growing at a pace considered as too low, the central bank is likely to lower the policy interest rate.

The Real Interest Rate Cannot Be Established without Money

Would it be possible in a world without money, such as presented by Wicksell, to establish the level of the interest rate on the lending of present apples in return for potatoes in the future? In a world without money, all that one could ascertain is the quantity of present goods exchanged for the quantity of various future goods.

For instance, one present apple is exchanged for two potatoes in one year's time. Alternatively, one present shirt is exchanged for three tomatoes in one year's time.

There is, however, no way to establish the level of the interest rate that a lender of an apple receives from the borrower of this apple that repays the loan by means of potatoes. It is not possible to calculate the interest rate on the loan, since potatoes and apples are not the same goods. Likewise, we cannot establish the interest rate on the lending of the shirt for future tomatoes.

We can only establish that one present shirt is exchanged for three future tomatoes. However, we cannot ascertain the level of the interest rate. Only in a framework with the existence of money can the interest rate be established. The following example provides an illustration of the interest rate formation.

John the baker, who produced ten loaves of bread, sells these loaves for ten dollars. Now, according to his time preference, John the baker is ready to become a lender of the ten dollars in return for eleven dollars in one year's time. 

Note that John the baker assigns a greater importance to the future eleven dollars versus the present ten dollars, otherwise he would not agree to become a lender of the ten present dollars. 

According to the time preference of Bob the shoemaker, he is willing to borrow the present ten dollars in exchange for eleven dollars in one year's time. The shoemaker assigns a greater importance to having the ten dollars in the present versus the eleven dollars in one year's time.

Hence, both John the lender and Bob the borrower agree to enter the financial transaction because they are both expecting to benefit from it.

Observe that both the monetary factor and the real factor (time preferences) are involved in establishing the market interest rate, which is 10 percent. Note that the baker has exchanged the ten loaves of bread for money first, i.e., the ten dollars. He then lends the present ten dollars for the eleven dollars in one year's time. Again, the interest rate that he secures for himself is 10 percent. As far as the shoemaker is concerned, he pays the 10 percent interest rate to baker.

Note that without the existence of money, the baker cannot establish the required quantity of future goods that is going to equate to the interest rate of 10 percent. Note that only by means of money can the market interest rate be ascertained.

Given that in the world without money the real interest rate cannot be established, it follows that the natural interest rate cannot be established either.

Please note that according to Wicksell the natural interest rate is established in a world without money. Additionally, note that according to Wicksell the natural interest rate is established as the rate at which the demand for physical capital coincides with the supply of physical capital. However, the demand and supply of physical capital cannot be established, since capital goods are heterogeneous and cannot be added up to a total.

Consequently, it is not possible to separate the real interest rate from the market interest rate. There is only one interest rate, which is established through the interaction of individuals’ time preferences and the supply and demand for money.

We can thus conclude that economists’ and central bankers’ attempts to establish the natural interest rate should be regarded as an impossible task. In a free market, without the central bank no one would be required to establish whether the market interest rate is above or below this imaginary natural interest rate.

Conclusion

The essence of central bank policymakers' thinking emanates from the ideas of the late nineteenth-century writings of the Swedish economist Knut Wicksell. According to Wicksell, the key to economic stability is targeting the market interest rate to the natural interest rate. But as our analysis has shown, it is not possible to isolate the so-called natural interest rate. Policies that are aiming at reaching an unknown goal run the risk of promoting more rather than less instability.

1. John Maynard Keynes, The General Theory of Employment, Interest and Money (London: Macmillan, 1936), p. 383.

2. Robert L. Hetzel, "Henry Thornton: Seminal Monetary Theorist and Father of Modern Central Bank," Federal Reserve Bank of Richmond Economic Review 73, no. 4 (July/August 1987): 3–16. Also, see Murray N. Rothbard, Classical Economics, vol. 2 of An Austrian Perspective on the History of Economic Thought ([Cheltenham, UK]: Edward Elgar, 1995), p. 177.

3. Knut Wicksell, Interest and Prices: A Study of the Causes Regulating the Value of Money (New York: Augustus M. Kelley, 1965), p. 102.

4. Karl Pribram, A History of Economic Reasoning (Baltimore: Johns Hopkins University Press,1983), p. 322.

5. Wicksell, Interest and Prices, p. 104.

6. Thomas M. Humphrey, "Interest Rates, Expectations, and the Wicksellian Policy Rule (Federal Reserve Bank of Richmond working paper 75-2, July 1975).

7. Wicksell, Interest and Prices, p. 107.

8. Pribram, A History of Economic Reasoning, p. 323.

9. Wicksell, Interest and Prices, p. 189.