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NOTE Appendix D

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Appendix D

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Interest Rates and Business Cycles

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It was the contention of John Maynard Keynes, still accepted by many academic economists, that interest rates are a purely monetary phenomenon.

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In his own words,

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The rate of interest is the reward for parting with liquidity for a specified period,

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a measure of the unwillingness of those who possess money to part with their liquid control over it.

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This theory not only ignores or contradicts most of what has been written by economists for the last two centuries,

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If Keynes' theory were right, short-term interest rates would be highest precisely at the bottom

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of a depression to overcome the individual's reluctance to part with cash then.

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But it is in a depression that short-term interest rates tend to be lowest.

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If the liquidity preference theory were right, short-term interest rates would be lowest

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at the peak of a boom, because confidence would be highest then, and everybody would

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be wishing to invest in projects and things rather than in money.

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But it is at the peak of a boom that short-term interest rates tend to be highest.

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It is not easy to prove this relationship statistically, partly because so many influences

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govern interest rates, and partly because there is no pure index of depression and prosperity.

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But Jeffrey H. Moore, Associate Director of Research of the National Bureau of Economic

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Research, who has done much work along this line, has, at my request, kindly furnished

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the data, and H. Irving Foreman, of the same organization, has prepared the accompanying

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chart.

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I hasten to add that neither is responsible for the conclusions I have drawn from it.

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The chart accompanied an article of mine in Newsweek on October 13, 1958, comparing

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Following the Federal Reserve index of industrial production with bank rates on short-term business

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loans in the 10-year period running from 1948 through part of 1958.

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The industrial production scale on the left and the interest rate scale on the right are

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ratio scales in order to bring out more clearly the proportional changes in the two indexes.

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The dots indicate comparative high and low points.

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The results show that the two indexes tend to go up or down together, or, more strictly

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speaking, the industrial production index leads and the interest rate index lags.

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This is what we might expect.

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When production has been low, demand for loans is low, and interest rates are low.

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As production increases, the demand for loans to expand production increases, and if the

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money and credit supply is not too elastic, interest rates tend to rise, but with a time

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lag.

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There is also, no doubt, a reciprocal and inverse influence of interest rates on production.

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Low interest rates, other things being equal, tend to encourage borrowing for subsequent

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production, and high interest rates tend to discourage borrowing for subsequent production.

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The chart gives only short-term interest rates.

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For completeness, long-term interest rates should be considered also.

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But the historical record does not lead to any substantial modification of the conclusions

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just reached.

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Those interested will find the relevant charts both in the monthly Federal Reserve chart

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Board Book and in the Historical Supplement to it, both published by the Board of Governors

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of the Federal Reserve System.

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There they will find, e.g. on page 21 of the monthly issue of October 1958 and on page

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37 of the Historical Supplement of September 1958, that short-term and long-term rates

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tend to go up and down together.

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From the monthly chart which covers only the period from the beginning of 1950 to the end

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of 1958, one might get the impression that short-term rates are almost always lower than

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long-term rates.

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From the historical comparisons running from 1865 to 1958, however, one may see that until

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about 1929, short-term rates oscillated both above and below long-term rates and were as

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often higher as lower.

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This is what theory would lead us to expect.

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The long-term interest rate for a given period is, at any moment, the composite speculative

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anticipation of what the average of future short-term rates will be over that period,

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corrected in periods of deflation or inflation, for anticipations regarding the future real

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purchasing power of the currency unit.

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These speculative anticipations will of course often prove wrong, but long-term rates will

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tend to vary less erratically and through a much narrower range than short-term rates.

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