Had Tom's latest contribution not left some misleading ends, I wouldn't 
bother to respond.  Ideas often have consequences, some of them quite 
severe.  On the question of understanding how interest rates as well as 
the general price level are determined, the theories that lead 
policymakers to do the wrong things are rather regrettable.   Wicksell's 
contributions are an example of that type, as I briefly note below.

Thomas Humphrey wrote:
> Assisted by James Ahiakpor's careful research, we may perhaps agree on 
> the following points:
>
> 1. Henry Thornton, David Ricardo, and Alfred Marshall, and perhaps 
> others too, all developed versions of the cumulative process (CP) 
> analysis before Wicksell. I would further argue that Thornton was 
> chronologically the first to present the CP analysis and that his 
> version was more thorough, complete, subtle, and sophisticated than 
> either Ricardo's or Marshall's version. But Ahiakpor may not agree.
>

Actually, David Hume's 1752 essay, "Of Interest," contains an earlier 
explanation of the cumulative process in which the pressing of newly 
acquired money (cash) into the credit or loans market sinks the market 
rate of interest.  But as the money is "digested" through the economy, 
prices rise (following the quantity theory), the demand for loanable 
funds rises and interest rates are restored to their previous level: 
"the disproportion between the borrowers and lenders is as formerly,  
and consequently the high interest returns" (Eugene Rotwein, 1970, 58).  
Hume's lesson for humankind is that interest rates are not permanently 
determined by the quantity of money but by the supply of savings or 
"capital" relative to its demand.  Money's influence is only temporary, 
what has come to be termed the liquidity effect (see, e.g. William 
Gibson, /JPE/, 1970 or Milton Friedman, 1972).  The price-level effect 
reverses the liquidity effect while the expectations effect takes 
interest rates to the opposite level from which the liquidity effect 
takes them. J.S. Mill's (/Works/, 3: 656) clarification of the 
expectations effect is the clearest I know.

Would that Wicksell had appreciated all that instead of claiming to find 
defects in the classical "capital" supply and demand theory of interest 
and the quantity theory of money.
> 2. Wicksell was inspired by Ricardo's version and perhaps Marshall's 
> too, although he didn't cite Marshall.
>
> 3. Ricardo, Marshall and company advanced a third reason -- in 
> addition to (i) diminishing marginal productivity of accumulating 
> capital stock, and (ii) bankers' hiking of their lending rates to 
> protect their cash reserves from depletion in the face of 
> inflation-induced cash drains into internal circulation and into 
> external outflows through the balance of payments -- to explain why 
> the differential between the natural and market rates of interest must 
> eventually vanish, thus ending the cumulative process. That third 
> reason was that rising prices, by increasing the nominal value of real 
> investment projects, necessarily increases the demand for bank loans 
> to finance those investments. The  resulting increased loan demand 
> eventually bids the loan rate into equality with the natural rate.
>
> Ahiakpor quotes Wicksell as saying that banks could keep the 
> cumulative process going forever causing the price level to rise 
> without limit. But that's true only in Wicksell's hypothetical pure 
> credit regime in which the money stock (called "credit" by Wicksell) 
> consists solely of bank deposits transferable by cheque and there 
> exists no reserve constraint and/or metallic cash base to limit 
> expansion of the money stock and price level. But even in this extreme 
> case in which there is no self-equilibrating market mechanism to 
> eliminate the gap between market and natural rates of interest, 
> Wicksell, ever the price-level stabilizationist, proposed that the 
> central bank supply the missing stabilizing mechanism in the form of a 
> feedback policy rule. The central bank would follow the rule requiring 
> it to adjust the market rate of interest in response to general price 
> movements so as to counter those movements and stabilize prices (and 
> the stock of bank money) at some desired level.
>

Of what use is a pure credit economy model -- no money (cash) exists -- 
when people are anxious to deal with the problem of inflation? What 
determines the price level before we consider its rate of change 
(inflation)?  Money (and commercial banks) existed in Sweden when 
Wicksell was writing his argument.
> Actually Wicksell prescribed not one feedback rule but two. The first 
> directs the central bank to adjust the market rate of interest in the 
> same direction that prices are moving, stopping only when price 
> movements cease. In Wicksell's own words: "If prices rise, the rate of 
> interest is to be raised; and if prices fall, the rate of interest is 
> to be lowered; and the rate of interest is henceforth to be maintained 
> at its new level until a further movement of prices calls for a 
> further change in one direction or another." This quote comes from 
> page 189 of his 1898 Interest and Prices.
>
> Wicksell's second rule has the central bank adjust the bank rate in 
> response to price deviations from target. Unlike the first rule, which 
> seeks merely to halt price movements, the second rule seeks to reverse 
> and thus negate those movements so as to restore prices to their 
> pre-existing target level. Thus on page 223 of Volume 2 of his 1906 
> Lectures on Political Economy Wicksell states that central bankers 
> must endeavor to reverse or roll back price movements by engaging in 
> "a raising or lowering of bank rates" in order "to depress the 
> commodity price level when it showed a tendency to rise and to raise 
> it when it showed a tendency to fall."
>
> Formal analysis reveals that both rules stabilize prices and money to 
> a certain extent in Wicksell's CP model. But a combination of both 
> rules together stabilizes them even more. True, Wicksell did not 
> propose that both rules be combined into one. But at least he 
> formulated some form of stabilizing policy rules for his hypothetical 
> pure credit regime and for mixed cash & credit regimes as well. 
> Wicksell was as strong an advocate of price-level stability as Irving 
> Fisher and David Ricardo.
>
In fact, interest rates may rise of fall without any actions from a 
central bank.  This is the message from David Hume's "Of Interest." An 
increase in the rate of savings relative to the demand for loanable 
funds decreases that rate of interest, and vice versa.  An increase in 
the demand for loanable funds, relative to the rate of savings, also 
increases the market rate of interest -- without hurting an economy's 
growth.  Tom's summary of Wicksell's advice to central bankers here 
reads very much like a dog chasing its tale. Central banks are more 
likely to be the cause of rising prices, from their excessive money 
creation, than anything else.  And then they are supposed to raise 
interest rates when prices rise.  Why not just focus on the price level 
(from an understanding of the quantity theory of money) and leave 
interest rates alone?  That message also comes from David Hume's "Of 
Money" (1752).  David  Ricardo repeats the point, arguing that the Bank 
of England cannot expect to control interest rates through its rate of 
money creation.  Irving Fisher reaches the same conclusion from his 
studies of David Ricarodo's and Alfred Marshall's works and repetition 
of the same warning.

To the extent that Knut Wicksell influenced J.M. Keynes with the thought 
that central banks have that much power in determining interest rates in 
market economies, he bequeathed a rather unhelpful legacy to monetary 
analysis and policy.  Would that modern central bankers read Hume's "Of 
Interest" and Smith's chapter on money in the /Wealth of Nations/.

Tom concludes with:

"Ahiakpor thinks that Wicksell is overrated and has been given more 
credit than he is due. In truth, however, Wicksell added so many 
innovations to classical monetary analysis as to merit the economics 
profession's esteem. But perhaps that should be the subject of another 
post. "

I will not respond to that post.  I have hinted above why I disagree 
with Tom's assessment of Wicksell's worth to sound monetary analysis.  
My 1999 article, "Wicksell on the Classical Theories of Money, Credit, 
Interest and the Price Level: Progress or Retrogression?" or chapter 7 
in my /Classical Macroeconomics/ document why I think Wicksell's work 
was a retrogression.

James Ahiakpor

-- 
James C.W. Ahiakpor, Ph.D.
Professor
Department of Economics
California State University, East Bay
Hayward, CA 94542

(510) 885-3137 Work
(510) 885-7175 Fax (Not Private)