The interest rate and prices in Britain, 1873–1913: A study of the Gibson Paradox

Abstract

Any satisfactory explanatory sketch of the economic history of Britain in the half century prior to the First World War must contend with the movements in both the aggregate price level, first deflation and then inflation, and the interest rate, first down and then up (see Fig. 1). To many historians the simultaneous deflation and decline of interest rates has suggested than an explanation lies in an apparent loss of vigor of the British economy. Others are more skeptical. The analysis presented here supports a view that both the price and interest rate movements were primarily caused by monetary developments and did not reflect significant changes in the underlying real forces in the economy. Most contemporary economists viewed the price decline as a monetary phenomenon. That view is embodied in the classical monetary theory of prices. Marshall (1887, pp. 192-193) summed up this view by stating that long-run movements of prices “are cheifly caused by changes in the amounts of precious metals relative to the business which is to be transacted by them, allowance being of course made for changes in the extent to which the precious metals are able at any time to delegate their functions to bank-notes, cheques, bills of exchange and other substitutes.” Many scholars since, however, have disputed this view principally because of the behavior of the interest rate during the period of falling prices. This parallel movement of the price level and the interest rate was labeled the “Gibson Paradox” by Keynes (1930) and has been seen to be inconsistent with a monetary cause of price decline. The reasoning may be summarized by quoting from a recent text book (Mathias, 1969, pp. 401):