Did Raising Interest Rates under the Gold Standard Really Increase Aggregate Demand?

I hope that I can write this quickly just so people won’t think that I’ve disappeared. I’ve been a bit under the weather this week, and the post that I’ve been working on needs more attention and it’s not going to be ready for a few more days. But the good news, from my perspective at any rate, is that Scott Sumner, as he has done so often in the past, has come through for me by giving me something to write about. In his most recent post at his second home on Econlog, Scott writes the following:

I recently did a post pointing out that higher interest rates don’t reduce AD.  Indeed even higher interest rates caused by a decrease in the money supply don’t reduce AD. Rather the higher rates raise velocity, but that effect is more than offset by the decrease in the money supply.

Of course that’s not the way Keynesians typically look at things.  They believe that higher interest rates actually cause AD to decrease.  Except under the gold standard. Back in 1988 Robert Barsky and Larry Summers wrote a paper showing that higher interest rates were expansionary when the dollar was pegged to gold.  Now in fairness, many Keynesians understand that higher interest rates are often associated with higher levels of AD.  But Barsky and Summers showed that the higher rates actually caused AD to increase.  Higher nominal rates increase the opportunity cost of holding gold. This reduces gold demand, and thus lowers its value.  Because the nominal price of gold is fixed under the gold standard, the only way for the value of gold to decrease is for the price level to increase. Thus higher interest rates boost AD and the price level.  This explains the “Gibson Paradox.”

Very clever on Scott’s part, and I am sure that he will have backfooted a lot of Keynesians. There’s just one problem with Scott’s point, which is that he forgets that an increase in interest rates by the central bank under the gold standard corresponds to an increase in the demand of the central bank for gold, which, as Scott certainly knows better than almost anyone else, is deflationary. What Barsky and Summers were talking about when they were relating interest rates to the value of gold was movements in the long-term interest rate (the yield on consols), not in central-bank lending rate (the rate central banks charge for overnight or very short-dated loans to other banks). As Hawtrey showed in A Century of Bank Rate, the yield on consols was not closely correlated with Bank Rate. So not only is Scott looking at the wrong interest rate (for purposes of his argument), he is – and I don’t know how to phrase this delicately – reasoning from a price change. Ouch!

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7 Responses to “Did Raising Interest Rates under the Gold Standard Really Increase Aggregate Demand?”


  1. 1 TravisV January 17, 2014 at 9:06 am

    TravisV from TheMoneyIllusion comments section here.

    See below:

    http://www.economist.com/blogs/freeexchange/2014/01/deflation-euro-zone-2?fsrc=rss

    Is Kevin O’Rourke correct to say that the international gold standard worked far better after 1896 than from the early 1870’s to 1896?

  2. 2 sumnerbentley January 17, 2014 at 11:38 am

    No, I was considering the period before 1913, when there was no central bank in the US. I believe the Gibson paradox applies to both short and long term rates, but am not certain. Someone should take a look at the original Summers and Barsky paper.

    And the interest rate is not the price of gold, so I didn’t reason from a price change.

  3. 3 David Glasner January 19, 2014 at 1:04 pm

    Scott, But in the period before 1913, there were central banks everywhere else. At any rate, even with no central bank, individual banks, especially large reserve city banks had an incentive to alter their lending rates in light of their gold reserve position, raising rates when they felt their gold reserves were inadequate and reducing rates when their gold holdings were larger than desired. My recollection of Barsky and Summers is that their primary focus was on consol yields (a very long term rate). You are right that the interest rate is not the price of gold, what I meant was that you were taking a change in the short-run interest rate as given without asking what was the cause of change in the short-run interest rate. Whether the interest rate was changing because the entire yield curve was shifting up or down or because the slope of the yield curve is changing makes a difference.

  4. 4 sumnerbentleys January 20, 2014 at 5:22 pm

    David, No, I was talking about the same interest rate as Barsky and Summers, long term rates. I do think that short and long rates were correlated, however, so the Gibson’s Paradox might also hold for short rates. I can’t say one way or another. And I agree the liquidity effect might produce a different correlation with short rates. But I don’t see anything I said that was incorrect.

  5. 5 Blue Aurora January 21, 2014 at 3:01 am

    Although this is belated and somewhat off-topic, David Glasner…have you read this article that was published in the European Review of Economic History four to five years ago?

    http://ereh.oxfordjournals.org/content/13/3/349.short

  6. 6 David Glasner January 21, 2014 at 7:12 pm

    Scott, I went back and had another look at your post. I think the problem is that you are using the expression “higher interest rates” throughout your post in such a way that it is not clear whether the “higher interest rates” were caused by a deliberate policy action of the monetary authority or by some market phenomenon independent of monetary policy. I pointed out that insofar as higher interest rates were caused by the monetary authority trying to increase its holdings of gold reserves, the higher interest rates would tend to decrease AD. But if that is why short-term interest rates were rising, it is not likely that long-term rates would rise much if at all. In the context of your general argument, you seemed to be focused on monetary policy as the cause of interest rate fluctuations, but I can see how you may have simply been thinking about the statistical relationship between AD and long term rates. But I would still fault you for not making clear that you have to specify the term of the interest rate and the cause of the movement of the interest rate, which still seems to me what would be required by the maxim never reason from a price change.

    It also occurs to me as I write this that it would be Hawtrey that would look at short-term rates as the instrument of monetary policy while it was Keynes who tried to argue that for monetary policy to be effective it has to affect long-term rates not just short-term rates. So that would have been your best response to my criticism.

    Blue Aurora, No I have never seen that article. Thanks for the reference. I just quickly read the abstract and it seems interesting. Two quick points come to mind. First, to a large extent the policy of the Bank of France was determined by the provisions of the legislation passed with the support of the Bank of France which required that holdings of foreign exchange be converted into gold, so it is not clear that the hypothesis of the paper that the policy was a rational response to risk of devaluation is factually correct. Second, the policy of the Bank of France was itself a major cause of the devaluation, so the Bank’s policy was a failure on its own terms. The abstract indicates that the authors recognize the second point at least.

  7. 7 Blue Aurora January 22, 2014 at 2:27 am

    David Glasner: I see. Will you please read it and later get back to me with your thoughts on the article?


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About Me

David Glasner
Washington, DC

I am an economist at the Federal Trade Commission. Nothing that you read on this blog necessarily reflects the views of the FTC or the individual commissioners. Although I work at the FTC as an antitrust economist, most of my research and writing has been on monetary economics and policy and the history of monetary theory. In my book Free Banking and Monetary Reform, I argued for a non-Monetarist non-Keynesian approach to monetary policy, based on a theory of a competitive supply of money. Over the years, I have become increasingly impressed by the similarities between my approach and that of R. G. Hawtrey and hope to bring Hawtrey's unduly neglected contributions to the attention of a wider audience.

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