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Week 3: Neoclassical school: Knut Wicksell and Irving Fisher (Wicksell…
Week 3: Neoclassical school: Knut Wicksell and Irving Fisher
Wicksell (1851-1926)-Major contributions
Aim
:Synthesize monetary theory, business-cycle theory, public finance, and price theory
contributions to monetary economics
i. Role of interest rates in achieving equilibrium price level
ii. Role for public policy to promote price stability
Wicksell-Monetary theory
Normal/natural interest rate vs. bank interest rate
Bank rate is determined by banking system
Bank rate < natural rate inflation
Bank rate > natural rate deflation
Natural rate depends on supply/demand of real capital that is not yet invested
Advocate of stabilizing monetary policy:
As long as prices remain unchanged, bank rate should be unchanged. When prices rise, the bank rate should rise. When prices fall, the bank rate should fall.
Role of interest rates in price determination (until then, quantity theory of money (Hume))
Fisher (1867-1947)-Theory of Interest
Equilibrium interest rate: impatience rate equal to investment opportunity rate
--> Real interest rate
Nominal interest rate = real rate + expected rate of inflation --> Fisher effect
Two factors influence interest rate:
Impatience rate
First to use indifference curves
Investment opportunity rate Diminishing marginal returns
Fisher-Monetary theory
Prices vary directly with the quantity of money (M, M’) and the velocity of circulation (V, V’), and vary inversely with volume of trade (T)
Changes in M disturb the optimum, make people adjust their cash/expenditure ratio, and as such changes prices:
--> Direct effec
t (recall indirect effect from Wickse
ll)
Monetary policy: control quantity of money as to face business cycle fluctuations.
Restated and extended quantity theory of money: MV + M’V’ = PT