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Roy J. Rotheim

brakes would achieve their policy goals but with no effect on the then perceived existing natural rate of unemployment. What happened, as we know, is that this exercise in extreme monetary restraint led to the greatest recession in the US since the Great Depression of the 1930s. Nominal interest rates soared, unemployment rose, although oddly enough inflation did not come down until there was a policy r­eversal 1   An earlier version of this chapter was presented to the Money and Development Seminar, SOAS. Comments by Victoria Chick are most appreciated. 27 M4534

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Hans-Michael Trautwein and Abdallah Zouache

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Edited by Louis-Philippe Rochon and Sergio Rossi

(the “naturalinterest rate), which makes supply and demand for saving equal as stipulated by the “loanable funds theory”. Nevertheless, to the extent that, in this conceptual framework, the long-term interest rate can deviate temporarily from the “naturalinterest rate, it is admitted that authorities may have temporary control over the long-term interest rate through the setting of the short-term interest rate. When the market’s long-term interest rate is below (above) the equilibrium interest rate, the economy is experiencing inflation (deflation), and the

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Edited by Heinz D. Kurz and Neri Salvadori

. (1827), Labour Rewarded, London: Hunt & Clarke. Ure, A. (1835), The Philosophy of Manufactures, London: Charles Knight. Interest and Profit The analysis of the relationship between the rates of interest and profit deals with how to integrate the theory of money with that of value and distribution. In this analysis, the notion of ‘money’ or ‘market’ interest rate is distinguished from that of ‘average’ or ‘natural’ or ‘real’ interest rate. The level of the latter is determined either by the same factors affecting the rate of profit or by other factors, including

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Edited by Louis-Philippe Rochon and Sergio Rossi

increases in the money supply is a proportionate increase in the domestic price level, which gives rise to a depreciation of its currency’s exchange rate. The direction of causality runs therefore from an exogenous money supply to the price level. This is intrinsically connected to the so-called “natural rate of interest theory” of New Keynesian economics (see Woodford, 2003 ). A natural rate of interest is determined in the long run by the equilibrium of savings and investment. This is a full-employment position for a given economy. A market interest rate that is

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Edited by Louis-Philippe Rochon and Sergio Rossi

the money market, but an instrument at the discretion of banks. In this respect, the bank’s function of issuing money adds to its traditional function of financial intermediation. On the loanable market funds, banks function as financial intermediaries, which allocate available savings to investment. Wicksell ( 1898 [1936], pp. 101–21; 1906 [1935], p. 193) calls the equilibrium rate of interest on this market, which also corresponds to the anticipated marginal productivity of capital, the “natural rate of interest”. The latter rate only coincides rarely with

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Massimo Pivetti

classical theory of distribution up to David Ricardo; the ‘fundamental phenomena’ of productivity and thrift, as far as marginalism is concerned. An important implication of this way of conceiving the relation between interest and profit is the denial of any substantial power on the part of the monetary authorities. Given the state of the real forces governing normal profit – the ‘natural real rate’ – the impact on the price level or on real output and accumulation of any lasting discrepancy between the courses of the two rates would force the monetary authorities to act so

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Edmund S. Phelps

3. Interest rate setting in the presence of investment prospects and Knightian uncertainty Edmund S. Phelps* The subject of this chapter is monetary policy. Wicksell around 1900 and Keynes in the 1930s were seminal figures. Wicksell argued that a central bank setting the interest rate below the ‘naturalinterest rate would cause rising inflation; Keynes that setting it above the natural rate would drive employment below what today we would call the ‘natural’ level. The splendid 1968 book of our honoree, Axel Leijonhufvud, was devoted to bringing out and

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Massimo Pivetti

classical theory of distribution up to David Ricardo; the ‘fundamental phenomena’ of productivity and thrift, as far as the neoclassical theory is concerned. An important implication of this way of conceiving the relation between interest and profit is the denial of any substantial power on the part of the monetary authorities. Given the state of the real forces governing normal profit – the ‘natural real rate’ – the impact on the price level or on real output and accumulation of any lasting discrepancy between the courses of the two rates would force the monetary

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Edited by Louis-Philippe Rochon and Sergio Rossi

) emphasized the relevance of Tooke as an economist “equipped with an infinite amount of practical experience and unhampered by any very great theoretical ballast”. After Tooke, only Wicksell realized the positive impact of lasting changes in the rate of interest on money and prices. His explanation, based on the marginalist theory of prices and distribution, is grounded in the variation of a non-observable natural rate of interest as a guide of money rates of interest. Obviously, the above-mentioned variation is inferred from the change in the money rate of interest, which