Wicksell’s Model of Price Movements – Explained!

Read this article to learn about the Wicksell’s model of price movements in quantity theory of money.

Introduction:

Knut Wicksell is the founder of the ‘Stockholm School’ of economics. He exercised profound influence on writings of the later economists like Ohlin, Lindahl, Myrdal.

These economists have refined and elaborated the ideas originally presented by Wicksell. They presented a coherent analysis of price movements and the trade cycle. The writings of J.M. Keynes and F.A. Hayek have also been influenced to a large extent by the ideas and analysis-of Wicksell.

It would not be wrong to describe Ohlin, Lindahl, Myrdal as the ‘Swedish Neo-Wicksellians’ economists on account of the great influence exercised by the writings of Wicksell. Wicksell presented his ideas and analysis in his two important books—’Lectures on Political Economy’ and ‘Interest and Prices.’ He is specially known for his ideas and analysis of price movements, trade cycle and his interpretation of crisis. Wick sell’s contribution appealed to be more striking because his analysis differs basically from that of his English contemporary economists of the classical school.

Wicksell found Tooke’s analysis of income, aggregate demand and prices highly suggestive and makes it the starting point for his theory of money and prices. But he did not agree with Tooke’s version of the role of interest in the dynamic process of income determination. Wicksell accepted Tooke’s analysis of the relation of income to prices. He tried to show how and why income (aggregate demand) rises and falls. His analysis of the relation of the rate of interest on loans (Market rate of interest) to the natural rate of interest is an outstanding contribution to the theory of income determination.

By concentrating on the rate of interest, he kept himself away from the narrow foundations of the quantity theory. According to him, investment was determined by the rate of interest in relation to the natural or real. A decline in the loan (market) rate below the natural (real) rate provides a stimulus to trade and production and alters the relation between supply and demand of goods and productive services. According to Wicksell, an increase in investment would raise aggregate demand and this in turn (at full or nearly full employment) will raise prices. If, on the other hand, loan rate is above the natural rate, the investment will decline bringing a fall in income, output, employment and prices.

In Wicksell’s analysis the rise and fall in income, output and prices is caused by the fluctuations in the marginal productivity of capital and the lagging adjustment of the rate of interest. Wicksell assumes interest elasticity of investment function but he fails to see that investment can be under certain conditions interest inelastic. He also did not see that interest rate policy at times becomes ineffective. His emphasis on interest rate manipulation to regulate the flow of aggregate demand and the level of prices is rather unwarranted.

Integration of the General Theory of Prices with Monetary Theory (Wicksell’s Approach):

Wicksell maintained that the general—supply and demand approach—which is helpful in the analysis of price formation of a single commodity should also be useful for explaining the absolute changes in the prices of all commodities in general. If the price of a commodity rises, we say that the demand has risen or the supply has fallen, in which case equilibrium is reached only at a higher price. Now, if there is a general rise in the price level (if all prices rise), it must be possible to explain it in the same manner, that is, it should be possible to say that the demand for all commodities rises or the supply of all commodities falls.

This view of Wicksell stand in sharp contrast with the traditional equilibrium theory which is based on Say’s Law of Market and maintained that there is no mechanism which makes certain that the amount people wished to spend on consumption and investment will be equal to the aggregate value of goods currently produced.

Wicksell pointed out that the decisions to save are taken by different classes of people. The amount one group intends to save may not be identical with what other groups intend to invest. In establishing the relations between total demand and supply of commodities, Wicksell was the forerunner of the modern monetary analysis. We thus find the germs of modern macroeconomic analysis in the Wicksellian analysis of price movements.

Wicksell held that one cannot simply assume an identity between demand and supply of consumption goods except in a state of static equilibrium because decisions to buy and sell are taken by quite different groups of individuals. Again, one cannot assume that capital (investment) demand and capital (saving) supply are identically equal because they also originate from different groups of people. The explanation of changed relationship between the demand for and supply of all consumption goods or more precisely between saving and consumption, and between investment and the production of goods, is found in the rate of interest. Thus, the link between price theory and monetary theory is provided by the rate of interest.

Wicksell’s Theory of Price Movements:

Another important feature of Wicksell’s theory is his explanation of the general movements of the price level. This he does with the help of his new concept of ‘monetary equilibrium’. This monetary equilibrium is brought about by an equality between the ‘natural rate’ and the ‘money rate’ of interest.

According to Wicksell economy is said to be in monetary equilibrium when the money rate of interest corresponds to the ‘real’, ‘normal’ or ‘natural’ rate of interest. This natural or normal rate of interest is called the equilibrium rate of interest by Wicksell. It is determined with reference to the conditions in the capital market, in the commodity market and conditions prevail concerning the round-about process of production.

When the economy is in equilibrium—money rate of interest being equal to normal rate of interest—price level is stable and the supply of and the demand for saving is equal. A divergence between these two rates of interest will start cumulative process in one direction or the other. This equilibrium is more likely to occur on account of the change in the natural rate of interest because it is this rate which is influenced by dynamic conditions on account of changes taking place in the economy as a result of inventions, technological or other improvements. This disequilibrium is more or less customarily determined.

A divergence between the money rate and the natural rate will start a cumulative process through its first and initial effects on capital values. If the money rate of interest lags behind the natural rate, the capital value of the existing real capital will increase. This will increase the possibilities of profit in the round-about process of production, this in turn, will render the production of real capital goods more profitable. Hence, the producers will shift and increase their activities from the production of real capital goods.

This will lead to a transfer of factors of production and resources between the two important sectors of production. The producers will be able to pay higher prices due to higher profit possibilities. All this will lead to an increase in national income.

As a result of rise in the prices of consumer goods, the capital values will increase further. There is a greater optimism about price expectations. This fresh increase in capital values, rise in profit and incomes, wave of optimism, keeps the process going in the upward direction in a cumulative manner and the whole process becomes self- strengthening. In other words, a boom feeds the boom, encouraging entrepreneurs to start longer and more round-about process of production, incomes, demand, capital values and so on.

This cumulative process does not stop so long as the difference between the natural rate of interest and the money rates of interest exist. The opposite effects will follow when the money rate of interest lies above the natural rate of interest. Its immediate result is a fall in the capital values especially in the durable and capital goods industry, leading to a decline in employment, fall in consumer incomes, fall in demand, and affecting unfavourably the capital values. If entrepreneurs remain pessimistic and expect a further fall in prices the down-trend will continue. This is, in brief, Wicksell’s cumulative process of the theory of price movements.

Criticism:

However, Wicksell’s integration of the general theory of prices, with monetary theory and his theory of price movements have been criticized on the following grounds:

(i) Neo-Wicksellian like Lindahl and Myrdal criticised Wicksell’s concept of ‘monetary equilibrium’. We have seen that Wicksell’s theory depends upon the notion of monetary equilibrium, because the Wicksellian cumulative process will operate in the upward or downward direction only if the system gets out of equilibrium in which it happens to be.

Wicksell’s model pre-supposes knowledge of whether a certain economic situation or price situation is, or not a position of monetary equilibrium, and if not, on which side of the equilibrium that economic or price situation lies. Both Myrdal and Lindahl have rejected Wicksell’s concept of monetary equilibrium on the grounds that it is far from clear and also false for various reasons.

(ii) Wicksell also maintains that an increase in savings will essentially lead to a shift in the use of the factors of production, thereby leading to an increase in investment in the capital goods industry. The Neo-Wicksellian like Ohlin and Myrdal criticised this idea. They uphold the view expressed by Keynes that an increase in saving may result in the demand being reduced, which, in turn, may result in losses to business firms and a decline in investment.

(iii) Again, it has been pointed out that generally, it is only in a stationary economy. Wicksell’s conditions of monetary equilibrium are easily fulfilled. It means choosing stationary economic state as the starting point. This method is quite unsatisfactory, as it evades the theoretical problems without solving them. In a stationary state, there is equilibrium even in respect of those relationships and variables the stability of which would be incompatible with monetary equilibrium under dynamic Conditions.

(iv) Myrdal has shown that the criteria of the normal rate of interest which Wicksell has assumed as mutually consistent with each other, are not really so. Wicksell has never shown or proved that these criteria are mutually consistent or even identical. His formulations in this respect are too loose and contradictory. Again, the natural or the normal rate of interest does not depend only on technical conditions, it depends also on the price situation and cannot be regarded as existing independently of the loan rate of interest and hence, independently of the price system.

(v) The assumptions of perfect foresight, greater mobility of factors and almost perfect competition are necessary for Wicksell’s model and the normal rate of interest as the rate which secures equilibrium between the demand for and supply of saving. However, under changing, dynamic frictional conditions as these operate in the real world, the matter is quite different. Moreover, the concept of normal rate is somewhat imperfect as it carries with it certain amount of arbitrariness. The normal rate of interest is defined as the rate which is neutral in relation to the price level, but a neutral rate of interest does not necessarily means unchanged price level. Therefore, the neutrality of the normal rate of interest in relation to price level in Wicksell’s model cannot be simply assumed.

Aftalion’s Analysis:

Aftalion, in 1925 made an effective statement of the income theory of money and prices, putting it for the first time in the form of an equation, R = PQ, where R stands for money income, P for price level and Q for total production. According to Aftalion, price fluctuations depend on the relative variations in money income in relation to real income. If the first increases while the second is stationary or lags behind, prices will rise.

Aftalion brings out the superiority of income theory over the quantity theory because income theory is not a simple truism or identity equations as the quantity theory is. Income theory introduces concepts of schedules of economic behaviour, that is, as the income changes, shifts also occur in the demand and supply schedules of goods and services.

Instead of approaching the problem mechanically as the quantity theory does the income theory is able to formulate the problem in terms which explains why buyers and sellers act as they do. The income theory, according to Aftalion, substitutes an explanation in terms of men for the explanation of the quantity theory which runs in terms of things. The income theory takes account of the incomes of individuals and the psychological effect of variations in income on demand and price.

The effect of an increase of incomes upon price level will be different, depending on who are the individuals affected. The increase of income does not affect the price level mechanically or automatically, rather, it operates through the desires of those whose incomes are raised. But Aftalion like Tooke, did not develop any systematic analysis of income determination. This important task was completed by Keynes in his General Theory published in 1936. Neither Wicksell nor Aftalion offered any satisfactory theory of income determination except a theory of upward or downward cumulative process.

Keynes Approach:

Dissatisfied with the earlier approaches to the quantity theory of money, Keynes developed the idea that price and output variations are due to variations in the level of income, which, in turn, are due to changes in the level of saving and investment, profit expectations, consumer expenditures, hoarding and dishoarding of money, creation and destruction of credit, etc. The income theorists rightly contend that changes in demand are a result of changes in income rather than money supply.

The aggregate demand for goods and services is determined by the size of the money income of the community, which in turn, given the elasticity of production, would raise the level of employment without affecting the prices. In fact, money supply may itself change due to movements in the level of income, prices and economic activity.

We know that in the economy, as a whole, income and expenditure are uniquely but essentially related. Income (Y) and expenditure (E) are one and the same thing, looked at from different points of view. Income is the basis of expenditure and all expenditures generate income. Therefore, what is needed for stability is the maintenance of the circular flow of money income in the economic system.

Money income refers to the sum total to payments made to the factors of production in the form of wages, interests, profits, rents, etc. This money income, at any time, is the result of money expenditures at that time (or of expenditures of the previous period). Money expenditure consists of expenditures of individuals, firms and government on goods and services produced in the economy during a given period. In any period of time, the value of money depends upon that flow of money income and its spending on the one hand and the How of real income on the other.

The flow of money income depends upon the quantity of money and its income velocity and the flow of real income (total goods and services) depends upon a number of factors (like techniques, productivity, resources, stage of economic development). We know that money income generated in any period is equal to the money value or goods and services produced (by hypothesis GNP ≡ GNE ≡ GNY)

It may, however, be noted that while expenditures automatically generate income all is not automatically spent. The money offered in the market for the new goods and services produced may be more or less than the money income given in their production. In other words, money expenditures is not limited to the income received because of hoarding and dishoarding and because of the creation and destruction of credit money. We know that income (F) is divided between consumption (C) and saving (S), therefore, Y = C + S. Further, expenditure (E) is divided into consumption-expenditure (C) and investment-expenditure (I), therefore, E = C + I. Since income (Y) is equal to expenditure (E), therefore, C + S = C + I, or S – I.

This is the fundamental condition which must be fulfilled in the economy if fluctuations in income, output, employment and prices are to be avoided and a particular level of income is to be maintained. It is this fundamental condition (S = I) which is not easily fulfilled. Saving is the failure to spend income on consumption, which creates a gap in the flow of money payments. This gap can be avoided only if money equal to the net amount withdrawn is put back into the income expenditures stream by an equivalent amount of investment. So long as I is equal to S, the total income will be equal to total expenditure (Y = C + I) and the income-expenditure flow will be maintained. If, however, investment is more than savings (on account of dishoarding or credit creation), both income and expenditure will rise, raising at the same time the volume of employment and the level of prices and vice-versa.

Thus, a disequilibrium between saving and investment causes fluctuation in incomes and expenditures, which, in turn, causes changes in prices and employment. Similarly, an excess of savings over investment can generate a depression. So long as savings continue to exceed investment, incomes and prices and employment will go on falling. Thus, it is clear that the general price level is more a matter of total income and total economic activity than the quantity of money alone.

Merits of Saving and Investment Version (Income Theory):

Saving and investment theory can explain a number of things about the behaviour of money that the quantity theory cannot. For example, it can explain why a shortage of money can more or less stop a boom but a large quantity of it cannot start a recovery. Moreover, the saving and investment theory sheds a good deal of light on the mysterious element—the velocity of circulation of money. It proves that, when saving exceeds investment, the community is increasing the proportion of its wealth that it wishes to keep in the form of money or money claims.

The velocity of circulation, therefore, falls and if more money is created, it may be held as money instead of being spent on investment. Prof. Crowther remarks, “This explains the puzzling phenomenon that, when money is created at the bottom of a depression, it sometimes has no effect on the volume of investment, so that in the terminology of the Quantity Theory, V goes down as rapidly as M goes up, leaving MV unchanged. When investment exceeds saving, the contrary influences come into play.”

This, however, does not mean that quantity theory of money is not true. The Quantity Theory does give us a long-term explanation of the behaviour of prices as a result of changes in the quantity of money. The relationship between savings and investment governs the short period fluctuations of prices. “The Quantity Theory of money explains, as it were, the average level of the sea, the saving and investment theory explains the violence of the tides.”

According to Hansen, a basic difference between the quantity theory and income theory can be stated in terms of two opposing interpretations of the equation Y = MV – PT (that is, money income equals money times income velocity and this in turn equals money value of output PT). “According to the Quantity Theory it is the quantity of money and its ‘behaviour’ (velocity) which explains the level of income. According to the income theory it is the flow of expenditures which explains the quantity of money and its velocity.”

Again while the quantity theory is based on the assumption of full employment, the income-expenditures approach offers explanation of the reaction of prices to the changes in the quantity of money, before the level of full employment is reached. Thus, the income-expenditure approach is more realistic as it indicates that the effect of a given change in the quantity of money in the price level is not a simple cause and effect relationship, as the quantity theory assumed, but a most complex chain of reactions and as such saving and investment theory provides a very useful way of discovering the forces that cause cyclical changes in prices and economic activity.