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Knut Wicksell was a Swedish monetary economist writing within the classical tradition in

the last decades of the nineteenth and the first quarter of the twentieth century and considered
himself to be an exponent of the quantity theory. His treatment of the quantity theory was
very distinctive and quite different from the English and American traditions of the time, as
represented in the works of Fisher, Pigou and Keynes during his classical period prior to 1930.
Further, elements of Wicksell’s analysis led to the formulation of modern macroeconomic
analysis. His ideas have assumed even greater importance in the past two decades since several
central banks in developed economies have adopted the use of the interest rate as their primary
monetary policy instrument, so that the appropriate analysis has to take the interest rate rather
than the money supply as being exogenously set. The money supply becomes endogenous in
this context. These assumptions are essentially similar to those made by Wicksell. The new
Keynesian analysis embodies these assumptions, so that it is sometimes referred to as the
neoWicksellian analysis.
Wicksell sought to defend the quantity theory as the appropriate theory for the determination
of prices against its alternative, the full cost pricing theory. The latter argued that each
firm sets the prices of its products on the basis of its cost of production, including a margin
for profit, with the aggregate price level being merely the average of the individual prices
set by firms. The amount of the money supply in the economy adjusts to accommodate this
price level and is therefore determined by the price level, rather than determining it. Wicksell
considered this full cost pricing theory as erroneous and argued that such pricing by firms
determined the relative prices of commodities, rather than the price level. In his analysis, the
latter was determined by the quantity of money in the economy relative to national output
since commodities exchange against money and not against each other.
In his reformulation of the quantity theory, Wicksell (1907) sought to shift the focus of
attention to the transmission mechanism relating changes in the money supply to changes
in the price level. He specified this mechanism for economies using either metallic or fiat
money and for a pure credit economy. The latter analysis is the more distinctive one and
illustrates Wicksell’s transmission mechanism more clearly. It is also the one likely to be
more relevant to the future evolution of our present day economies and, therefore, is the one
presented below.
In modern macroeconomic terminology, Wicksell’s analysis of the pure credit economy
is essentially short run since his analysis assumes a fixed capital stock, technology and
labor force in the production of commodities. This focus on the short run contrasts with
Fisher’s and Pigou’s reliance on the long-run determination of output in order to establish
their versions of the quantity theory. Further, Wicksell assumes that the economy is a pure
credit one in the sense that the public does not hold currency and all transactions are paid
by checks drawn on checking accounts in banks, which do not hold any reserves against
their demand deposits. Since the banks do not hold reserves and any loans made by them
are re-deposited by the borrowers or their payees in the banks, the banks can lend any
amount that they desire without risking insolvency. Further, banks are assumed to be willing
to lend the amount that the firms wish to borrow at the specified market rate of interest
set by the banks. Wicksell calls the nominal rate of interest at which the banks lend to
the public the money or market rate of interest. The banks accommodate the demand for
loans at this interest rate, which is set by them. Under these assumptions, the amount of
money supply in the economy is precisely equal to the amount of credit extended by the
banks, since these loans are wholly deposited in the banks. Hence, changes in the money
50 Introduction and heritage

supply occur only when the demand for loans changes in response to an exogenous shift
in the interest rate charged by banks. Note that, in Wicksell’s pure credit economy, the
economy’s interest rate is set exogenously by the banks, while the money supply depends
on this interest rate and the public’s demand for loans. Therefore, it is endogenous to the
A critical element of Wicksell’s (1907) theory is the emphasis on saving and investment
in the economy. Funds for (new) investment come from saving plus changes in the amount
of credit provided by banks. The rate of interest which equates saving and investment was
labeled by Wicksell the normal rate of interest. Since Wicksell’s pure credit economy was a
closed one and there was no government sector, the equality of saving and investment means
that the normal rate of interest is the macroeconomic equilibrium rate. Further, if the market
interest rate equals the normal rate, there will be no change in the credit extended by banks
and, therefore, no change in the money supply. For a stable amount of credit and money
supply in the economy, the price level will remain unaltered. To conclude, at the market rate
of interest equal to the normal one, there is equilibrium in the commodity market, Further,
with stable output and money supply, the normal rate of interest will be accompanied by a
stable price level.
Firms borrow to finance additions to their physical capital. The marginal productivity of
capital specifies the internal rate of return to the firm’s investments and was referred to by
Wicksell as the natural rate of interest. The firm’s production function has diminishing
marginal productivity of capital, so that, with a constant labor force and unchanged
technology, the natural rate of interest decreases as capital increases in the economy.
To see the mechanics of this model, start from an initial position of equilibrium in the
economy, with a stable money supply and prices, and with the equality of the market/loan
and natural rates of interest at the normal/equilibrium rate of interest. Now, suppose that
while the market rate of interest is held constant by the banks, the marginal productivity of
capital rises. This could occur because of technological change, discovery of new mines, a
fall in the real wage rate, etc. Firms can now increase their profits by increasing their capital
stock and production. To do so, they increase their investments in physical capital and finance
these by increased borrowing from the banks. This causes the amount of credit and money
supply in the economy to expand.
Wicksell appended to this analysis the disaggregation of production in the economy
between the capital goods industries and the consumer goods industries. As the demand
for investment in physical capital increases, factors of production are drawn into such
industries from the consumer goods industries, so that the output of the latter falls. At
the same time, the competition for labor and the other factors of production will drive up
workers’ incomes, leading to an increase in the demand for consumer goods, thereby pushing
up prices. Consequently, the price level will rise, though with a lag behind money supply
changes. Analysis based on this disaggregation of production between the capital goods
industries and the consumer goods industries is not a feature of most modern macroeconomic

Cumulative price increases (the inflationary process)

In the above process, initiated by a reduction by the banks of the market interest rate below
the natural one or by an increase in the latter above the market rate, the price rise will
continue as long as the market rate of interest is below the natural rate, since the firms will
then continue to finance further increases in investment through increased borrowing from
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the banks. This constitutes a process of cumulative price increases. These increases can only
come to an end once the banks put an end to further increases in their loans or credit to firms.
A closed pure credit economy does not provide a mechanism that will compel the banks to
do this.
However, in an open economy where the banking system keeps gold reserves out of which
deficits in the balance of payments have to be settled, gold outflows provide a limit to the
cumulative price increases. In such a context, as prices continue to increase, foreign trade
deficits develop, the gold reserves of banks fall and the banks raise their loan rate of interest
to the natural rate to stem the outflow of gold. This is especially so if the banks hold gold
as part of their reserves and the public holds gold coins circulating as currency for some
transactions. In the latter case, as prices rise, the public’s demand for currency will also
increase and gold will flow out of the banks’ reserves to the public. Such losses of the gold
reserves to the public and abroad forces banks to restrict their lending to the firms by raising
their loan rate to match the natural rate. This puts an end to the cumulative credit and money
supply increases and therefore to the cumulative price increases.
This cumulative process can also be initiated by banks arbitrarily lowering the market
rate below the natural rate, with the resultant adjustments being similar to those specified
above for an exogenous increase in the natural rate. However, Wicksell viewed the bankers
as being conservative enough not to change the market rate except in response to changes
in their gold holdings or an exogenous change in the normal rate. Therefore, in Wicksell’s
view, the cumulative price increase was usually a result of exogenous changes in the marginal
productivity of capital impinging on an economy whose credit structure responds with gradual
and possibly oscillatory adjustments – for example, if the banks sometimes overdo the
adjustment of the market rate.

Wicksell’s re-orientation of the quantity theory to modern macroeconomics

Wicksell’s treatment of the pure credit economy clearly re-oriented the quantity theory in the
direction of modern macroeconomic analysis. Several features of this analysis are relevant
to modern macro and monetary economics. Among these is Wicksell’s focus on the shortrun
treatment of the commodity market in terms of the equilibrium between saving and
investment, a focus that was later followed and intensified in the Keynesian approach, as
well as in the IS–LM modeling of short-run macroeconomics. While Wicksell claimed to
be a proponent of the quantity theory of money, he shifted its focus away from exclusive
attention on the monetary sector, for example, as in Pigou’s version of the quantity theory,
to the saving-investment process. In doing so, he led the way to the formulation of current
macroeconomics, with the treatment of the commodities market at its core. This was to appear
later as the IS relationship of modern macroeconomics.

Wicksell introduced into macroeconomics a fundamental aspect of the modern monetary

economies: loans are made in money, not in physical capital, so that the rate of interest on
loans is conceptually different from the productivity of physical capital. Even if they are
equal in equilibrium, they will usually not be equal in disequilibrium. These ideas led the
way to the analysis of the impact that the financial institutions and especially the central bank
can have on the interest rates in the economy and on national income and employment.
Wicksell’s analysis of the pure credit economy also emphasized the role of interest rates
and financial institutions in the propagation of economic disturbances, since they control the
market interest rate, reduction in which can set off an expansion of investment, loans and
the money supply and lead to a cumulative increase in prices and nominal national income.
52 Introduction and heritage

Further, Wicksell assumed that the banking system sets the interest rate rather than the
money supply as the exogenous monetary constraint on economy. This assumption was
not followed by the expositions of macroeconomic theory in either the classical or the
Keynesian formulations until the end of the twentieth century, since they continued to take the
money supply as their exogenously determined monetary policy variable. Since the moneydemand
function proved to be unstable in most developed economies after the 1970s, thereby
implying the instability of the LM curve, many central banks now choose to use the interest
rate as the monetary policy variable and set its level, while allowing the economy to determine
the money supply as an endogenous variable for the set interest rate. This practice came to
be reflected in the theories offered by the new Keynesian approach after the early 1990s.
Wicksell was clearly the precursor of this type of analysis.
However, compared with the Keynesians, Wicksell, just like Fisher and Pigou, did not pay
particular attention to the changes in the national output that might occur in the cumulative
process. While he discussed disequilibrium and transient changes in national output during
this process, he was not able to shake off the classical notion that the economy will eventually
be at full employment, so that his overall discussion was usually within the context of an
implicitly unchanged equilibrium level of output. Given this background, Wicksell claimed
that increases in the money supply are accompanied sooner or later by proportionate price
increases. Keynes’s General Theory (1936) was to question the implicit assumption of an
unchanged level of output and to allow for changes in output and unemployment following
a change in aggregate demand. Merging this possibility into Wicksell’s cumulative process
would mean that his cumulative process would possess both output and price increases
(decreases) whenever the market interest rate was below (above) the natural rate.
Hence, while Wicksell claimed nominal adherence to the traditional classical approach
and the quantity theory, his theoretical macroeconomic analysis differed from theirs and
was quite modern in several respects. One, in terms of this theoretical analysis in terms
of saving and investment, Wicksell was a precursor of the Keynesian and modern shortrun
macroeconomic analysis. Two, in terms of his assumption of a pure credit economy,
he presaged current developments in the payments system. Three, his assumption that the
financial system sets the interest rate rather than the money supply as exogenous, he was a
precursor of current central bank practices and the analysis of the new Keynesian models in
the last couple of decades.
However, Wicksell’s analysis did have at least several deficiencies relative to current
monetary economics. One, although Wicksell did approach equilibrium through the normal
interest rate which equates saving and investment, he did not present a theory of aggregate
demand and also did not present the analysis of the impact of changes in it on output
and employment. These were to be later addressed by Keynes. Two, Wicksell did not
distinguish between real and nominal interest rates, which Fisher’s equation later clarified.
Three, he did not pay much attention to the analysis of the demand for money, on which
Keynes made very significant contributions which provide the basis for its modern mode of