Krugman – more Wicksell than Keynes

6 Jun, 2013 at 20:15 | Posted in Economics | 4 Comments

In a recent blogpost Paul Krugman comes back to his idea that it would be great if the Fed stimulated inflationary expectations so that investments would increase. I don’t have any problem with this idea per se, but I don’t think it’s of the stature that Krugman seems to think. But although I have written extensively on Knut Wicksell and consider him the greatest Swedish economist ever, I definitely – since Krugman portrays himself as “sorta-kinda Keynesian” – have to question his invocation of Knut Wicksell for his ideas on the “natural” rate of interest. Krugman writes (emphasis added):

Start with the very simplest view of how Fed policy affects the economy: the Fed sets short-term interest rates, and other things equal a lower rate leads to higher output; the “natural rate” of interest … is the rate at which output equals potential, that is, at which there are neither inflationary nor deflationary pressures …

What does this tell us? First of all, that there is nothing “artificial” or “unnatural” about low interest rates; they’re low because demand is low, and the Fed is responding appropriately. If anything, the “unnatural” situation is that rates are too high, because they’re constrained by the zero lower bound (rates can’t go below zero, except for some minor technical bobbles, because people can always just hold cash).

wicksell3Second, the Fed’s inability to get rates as low as they should be justifies a search for policies that can fill this policy gap. Fiscal stimulus is one such policy; unconventional monetary policies of various kinds are another. Actually, the natural policy — natural in a Wicksellian sense, and also the one that in terms of standard economics should produce the least distortion — would be a credible commitment to higher inflation.

Now consider what Keynes himself wrote in General Theory:

In my Treatise on Money I defined what purported to be a unique rate of interest, which I called the natural rate of interest¾namely, the rate of interest which, in the terminology of my Treatise, preserved equality between the rate of saving (as there defined) and the rate of investment. I believed this to be a development and clarification of Wicksell’s ‘natural rate of interest’, which was, according to him, the rate which would preserve the stability of some, not quite clearly specified, price-level.

I had, however, overlooked the fact that in any given society there is, on this definition, a different natural rate of interest for each hypothetical level of employment. And, similarly, for every rate of interest there is a level of employment for which that rate is the ‘natural’ rate, in the sense that the system will be in equilibrium with that rate of interest and that level of employment. Thus it was a mistake to speak of the natural rate of interest or to suggest that the above definition would yield a unique value for the rate of interest irrespective of the level of employment. I had not then understood that, in certain conditions, the system could be in equilibrium with less than full employment.

I am now no longer of the opinion that the [Wicksellian] concept of a ‘natural’ rate of interest, which previously seemed to me a most promising idea, has anything very useful or significant to contribute to our analysis. It is merely the rate of interest which will preserve the status quo; and, in general, we have no predominant interest in the status quo as such.


  1. “it would be great if the Fed stimulated inflationary expectations so that investments would increase. I don’t have any problem with this idea per se” I have numerous problems with the idea.

    1. There is no obvious reason why the optimum mix of investment and consumption spending changes as between when an economy is in recession and more normal times – i.e. why no just boost consumption spending and leave it to employers to invest as they see fit? Employers do not need advice from politicians or economists as to when and how much to invest.

    2. Inflation obviously reduces real interest rates and induces people to turn cash into real assets, i.e. invest. That would stimulate demand. But that effect could be nullified by another effect: the fact or possibility that households aim for a specific level of what Modern Monetary Theorists call “net financial assets”: i.e. monetary base and government debt.

    Inflation reduces the real value of the latter, and households could react by saving more: and that would reduce demand.

    3. Low interest rates encourages asset price bubbles.

    • Well said, Raplph. I agree with all three of your bullet points.

  2. Excellent. Thank you. I will “Evernote” this for future reference. Talk of the “natural interest rate” drives me crazy, along with the suggestion that the Fed should make a credible commitment to higher inflation without specifying how the Fed will fulfill that commitment…

  3. Investment only produces part of the income necessary for households to buy your products…

    …wonder where the rest comes from?

Sorry, the comment form is closed at this time.

Blog at
Entries and Comments feeds.