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

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))

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

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:

  1. Impatience rate
     First to use indifference curves
  1. 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)

Monetary policy: control quantity of money as to face business cycle fluctuations.

Restated and extended quantity theory of money: MV + M’V’ = PT

Changes in M disturb the optimum, make people adjust their cash/expenditure ratio, and as such changes prices:
--> Direct effect (recall indirect effect from Wicksell)