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Michael Dotsey


This article focuses on various ways that the implicit rate on demand deposits can be measured, and
the effects of using these implicit rates in analyzing
the demand for money. The presence of implicit
payments on demand deposits is a likely result of the
competitive nature of the banking system. Deposits
are a primary source of funds that banks can use to
earn a market rate of return. Competitive pressures
should force banks to offer depositors something in
return for the use of transactions balances. Since
the payment of explicit interest on transactions accounts was forbidden until the introduction of NOW
accounts in 1973, and was regulated prior to the
advent of "Super NOW” accounts in 1983, banks
were forced to compete for all transactions balances
in a nonprice manner. This type of competition continues to occur with respect to demand deposits and
smaller NOW accounts. Some ways that this can be
done is by remitting service charges, providing cash
management services at subsidized rates, and giving
preferential treatment on loans to depositors.
Since the competition for deposits by the banking
system is likely to result in some form of implicit
payment, it is important to incorporate this behavior
when studying the demand for money. Omitting the
implicit return on demand deposits in a money demand equation is likely to result in misspecification,
therefore biasing at least some of the estimated coefficients. Potentially, this bias could be serious enough
to substantially affect the ability of the equation to
predict future money demand. This could lead to the
unwarranted conclusion that the demand for money is
unstable and that the Federal Reserve should accommodate shifts in the money demand curve when in
fact no shifts have taken place.
Another related area where knowledge of implicit
interest payments is of importance is in understanding the effects of deregulation in the banking indus-

try. The relative desirability and growth of new
types of accounts, such as “Super NOWs,” will
depend on the advantages they have over existing
accounts. This will involve a comparison between
the current implicit payments made on demand deposits and the explicit (as well as any implicit) payments accompanying the new accounts.
In order to analyze implicit interest rates and their
effects on money demand, three different estimates
of the implicit rates on demand deposits are examined. Specifically, the studies of Startz [12], Barro
and Santomero [1], and Klein [8] are reviewed.
Each of these articles provides very different methods
of arriving at an estimate of implicit rates. Startz
uses accounting data to calculate a measure of services remitted, while Barro and Santomero use a
private survey to derive a marginal rate of remittance. Klein, on the other hand, assumes that banks
costlessly evade regulations and pay a competitive
rate. Given the differences in methodology, it is not
surprising that the actual estimates differ. However,
all three estimates are highly correlated and show
movements in the same direction. One may, therefore, have more confidence in the way in which implicit rates have changed than in their actual level.
An analysis of the effects of implicit interest rates
on the demand for money is also presented. The
rate derived by Barro and Santomero performs
especially well. The competitive rate calculated by
Klein also seems useful although there exist econometric problems in interpreting its effect.
The paper proceeds as follows. Section II discusses the derivation of each of the three implicit
rates and indicates some of the problems with each
construction. Section III compares the time series
properties of the various rates while section IV discusses the use of implicit rates in studying the demand for money. Section V contains a brief conclusion.




Startz's Method: The Use of
Accounting Data1
In an interesting piece of research Startz constructs two basic measures of the implicit rate on
demand deposits. One uses Functional Cost Analysis
data, while the other uses the reports of income and
condition of all insured commercial banks. It is the
latter that will be reviewed here.2
Specifically, Startz’s measure of implicit interest
is composed of those expenses incurred in maintaining a deposit account that are not charged to the
customer. Since banks are involved in joint production, it is difficult to allocate expenses in an unambiguous manner. To overcome this problem it is
assumed that all noninterest expenses are linearly
allocated to demand deposits, time deposits, and
loans. Further, each activity is assumed to be independent. Expenses are then allocated by the use of a
linear regression of net expenses on demand deposits,
time deposits, loans, and a constant, where the coefficient on demand deposits has the interpretation of
an implicit rate.3 The regression is depicted by
equation (1)

where NETX are total bank expenses net of service
charges, DD are demand deposits, T are time deposits, L are loans, and e is a stochastic error term.
The regression is run on a combined time series/cross
section data set for each of the fifty states and the
District of Columbia over the years 1973, 1974, and
1975. The coefficients on time deposits and loans
are constrained to be constant (a constraint that can
not be statistically rejected).
Even though this constraint can not be rejected
over the period 1973-75, it seems unlikely that CT
would be constant over the sample period 1954-68.
This is because interest rate ceilings that were imposed on time and savings accounts in 1966 were
binding over most of the 1973-74 period. Therefore,

For another excellent example, see Becker [2].

The method using Functional Cost Analysis data was
not examined because over time the data are somewhat
incompatible due to changes in the sample of banks participating in the survey, and changes in the way that
indirect expenses are allocated.


For a more detailed breakdown of net expenses, see the
appendix to Startz [12].


these deposits may have been subject to some implicit
payment as well. This would make CT higher than
when interest rate ceilings were nonbinding or nonexistent and consequently would bias the estimates
of Startz’s implicit rates downward over the early
part of the sample.
The implicit rate calculated by Startz, RDDS, is
obtained by using the estimated coefficients CT and
C L from the regression depicted in equation (1) to
impute some of the noninterest expenses to time
deposits and loans. Specifically, the volume of loans
on the end of year balance sheets of insured commercial banks is multiplied by CL and the amount of time
deposits is multiplied by CT . The sum of these two
components is subtracted from net expenses. The
remaining amount of expenses is attributed to demand deposits and is divided by the level of demand
deposits yielding an average implicit rate. This
slightly overstates the average rate since the constant
in equation (1) is not actually zero, but small and
positive. The results of this procedure, for the years
1954-68, are reported in column 1 of table I. This
implicit rate is seen to be neither zero nor is it the
equivalent of a competitive rate.
While Startz’s procedure is interesting, it does
contain a number of conceptual problems, many of
which are pointed out by Rush [10]. The major
problems involve the use of accounting data. These
data are not conceptually equivalent to measures that
are economically important. Specifically the data
used by Startz underestimate true economic costs
since they omit a normal rate of return as an opportunity cost, giving a downward bias to his implicit
rate. This opportunity cost is the cost of attracting
capital to the bank.
Another equally important point is that the numbers contained in the report of income and condition
are incapable of reflecting the extent to which foregone earnings enter the implicit rate. For instance,
if a depositor is charged a lower loan rate based on
his average demand deposit balances, this would constitute an implicit payment on these balances, but
would not be reflected as an expense on the bank’s
accounts. Therefore, the bank’s foregone earnings
will not be allocated as part of an implicit rate on
demand deposits. As a practical matter Rush shows
that this downward bias is important.
Another problem with Startz’s procedure is that it
uses average costs and therefore produces an average
rate of return. In terms of economic behavior it is a
marginal rate that is important. That is, individuals
will determine the amount of their money holdings in


Table I
Barro and






























































































any particular account based on what the next dollar
will earn when placed in that account. Therefore,
for Startz’s measure of an implicit rate to be useful,
the average rate must closely approximate the marginal rate of return on demand deposits. This may
not be the case especially with regard to individual
demand deposit accounts. In many instances the
amount of services provided for an account is not
directly related to average balances but to the activity
within the account. Banks often provide free processing of checks based on a minimum balance or
minimum average balance requirement. For accounts
meeting these requirements the amount of free services an individual receives depends upon the amount
of checks written, and not on the amount of money
on deposit. Therefore, although the average return
on demand deposit balances is positive, the marginal
return is zero.4

Also, since it is the value placed on services that is
important, using cost data brings about another problem. This implicit rate can move for two distinct
reasons, each of which has a different implication.
In one case the implicit rate could rise because more
services are being provided free of charge, while in
the second case existing services could become more
costly. Only in the first case would the depositor
place a greater return on the holding of demand

As the level of market interest rates changes banks
seem to respond by changing minimum and minimum
average balance requirements, thus changing the point at
which demand deposits in certain types of accounts
earn a marginal rate of zero. For instance, a prolonged
rise in the level of interest rates would prompt banks to
change their minimum balance requirements. A marginal
rate of zero would occur at a lower level of balances and
individuals would hold less money in a demand deposit

account. One also would expect that measurements of
implicit interest rates would rise as well, and that the
implicit rate is proxying for this type of behavior. Including an implicit rate might therefore be preferable to
omitting it, but it would be better to analyze the relevant
factors determining the level of demand deposits directly.
Since banks offer a menu of accounts, the optimal procedure would be to analyze each type of account separately. For an example of this, see Boyd [4].


Barro and Santomero’s Method: The
Construction of a Marginal Remittance Rate
Another method for constructing implicit rates is
employed by Barro and Santomero [1]. By using a
private survey the authors are able to obtain the
rate at which charges are remitted as a function of



average deposit balances.5 This rate of remittance
can be used to calculate a marginal rate of return on
demand deposits since it indicates the rate earned by
an extra dollar of demand deposits. Because this
rate is a marginal rate and is derived from an actual
schedule of remittance it is a valuable contribution to
the literature on implicit interest rates.
The implicit rate calculated by Barro and Santomero, RDDBS, is displayed in column 2 of table I.
Like Startz’s rate, this rate is not zero. Its movement also appears to closely follow the movements
in the rate paid on savings and loan shares, RS
(column 4, table I). The differential between RS
and RDDBS is fairly constant, especially over the
latter part of the period when the authors indicate
greater confidence in their implicit rate calculations.
RDDBS also does not appear to be equivalent to a
competitive rate.
A weakness of this approach is that it is limited to
accounts in which service charges are remitted as a
function of average balances. This practice while
common for commercial depositors is not widely used
for household accounts. As pointed out by Boyd [4],
banks tend to offer an array of accounts that provide
services and remit charges in different ways. Some
accounts require minimum balances, while others
base their remittance of charges on average balances.
Some even tie their schedule of services with the
holding of funds in other types of accounts.
It may be that the rate calculated by Barro and
Santomero is not an exogenous constant from the
standpoint of the depositor. The depositor may be
able to influence the rate by altering his average balances. (This would be especially true if the remittance rate were nonlinearly related to deposit size.)
For instance, once deposit balances have grown to the
point where all service charges have been remitted,
the return on the next dollar deposited would be zero.
However, once a depositor reached this point the
bank would presumably reward him in other ways.
Barro and Santomero asked the top 100 commercial
banks to provide a time series for the remittance of service charges on various types of demand deposit accounts
as a function of average balances. They used the rate
information on smaller accounts in the hope of excluding
commercial accounts, or at least large commercial accounts. A typical piece of information would be that
service charges were remitted at the rate of $.15 per
month per 100 dollars of average balances, which would
correspond to a rate of 1.8 percent. This was appropriate
for the purposes of their study since they concentrated
on household accounts. For an examination of M1 it is
necessary to also include a measure of the implicit rate
received by businesses, or to study the demand for money
by households and businesses separately. Data limitations make it difficult to implement the latter suggestion.


The derived rate of Barro and Santomero also
assumes that an account receiving implicit interest
through remittance of service charges is receiving
only this particular benefit from the bank. If a demand depositor simultaneously received a remittance
plus favorable terms on a loan, the terms being
based on average deposit size, then the Barro and
Santomero measure would understate the true implicit rate. Essentially, one can view the Barro and
Santomero rate as the correct marginal rate under
the assumption that banks tailor the means of paying
an implicit rate to their customers, and that each
method roughly yields the same rate. In this context
the rate calculated for one type of account would be a
reasonable approximation for rates on all types of
Klein’s Method: A Competitive Rate
The third method examined is a competitive implicit interest rate derived by Klein [8]. Klein
reports an implicit rate for M1, but this is easily
converted into an implicit rate on demand deposits.
The results are displayed in column 3 of table I.
Basically Klein assumes that the regulation forbidding explicit interest payments on demand deposits is
costlessly evaded. Competitive pressures within the
banking industry force banks to offer the equivalent
of a competitive rate in order to attract depositors.
Formally, Klein’s implicit rate, RDDK, is expressed in equation (2).

Defining notation: DD are demand deposits, RCP is
the rate of 4-6 month commercial paper, rD D a r e
reserves held against demand deposits, rD are total
reserves, RCPW is a weighted annual average of the
commercial paper rate with the weights being determined by monthly discount window borrowings,
R D I S W is a similarly weighted average of the discount rate at the Federal Reserve Bank of New York,
GDD are government demand deposits, rG are reserves held against government demand deposits and
are assumed to be the same as the average for ordinary demand deposits, LD are expected losses on
deposits and are zero for the period 1954-68 examined in this study, and SD D are average service
charges per dollar of demand deposits.


Equation (2) implies that banks remit the short
term market rate of interest adjusted for reserves
held against demand deposits, plus any subsidies
received from discount window borrowings and the
holding of government deposits (government deposits
receiving a zero rate of interest) minus service
charges. With the exception of the last term, Klein’s
rate may be interpreted as a marginal rate if the
level of discount window borrowings permitted and
the level of government demand deposits at a bank
are related to bank deposit size. Also, this rate is
likely to be highly collinear with the commercial

maining terms in equation (2) do not possess sufficient variability.
Klein’s rate has certain attractive properties not
found in the other two rates. Unlike Startz it doesn’t
use accounting data and therefore doesn’t suffer from
the biases inherent in that procedure. Also, Klein’s
derivation doesn’t require any assumptions about the
specific way that implicit interest payments are made,
or the relationship between various ways of making
such payments. It therefore circumvents some problems that potentially affect the Barro and Santomero
However, Klein’s rate is not without problems.
For example, the level of services provided by banks
to depositors may not adjust continuously with
changes in market rates. That is, it may be very
costly to make instantaneous adjustments in the level
of services provided or the technology for producing
services may be such that continuous adjustment is
impossible. Banks may only be able to offer a discrete set of services and may require market rates to
move by some threshold amount before offering additional services.
The ability to offer a competitive rate that adjusts
rapidly may be more of a problem regarding household accounts than it is with respect to corporate
accounts. For instance, large corporate customers
often use many different services ranging from the
extension of credit at favorable terms to sophisticated
cash management techniques. The terms at which
credit is extended are often related to average demand deposit holdings, while cash management services are paid for by some combination of compensating balances and fees. The method of payment is
tailored to each customer and the rate that compensating balances yield is tied to market rates dis-

counted by some portion of the reserve requirement.6
These rates are usually adjusted monthly making the
implicit rate very close to a competitive rate for large
corporate customers. It is unclear whether such easy
adjustment is possible for depositors who do not
use a large array of bank services.
Some indirect evidence presented by Rush [10]
implies that a competitive implicit rate is not a bad
approximation. He compares the relative change in
bank profitability between banks in New England
States offering NOW accounts (Massachusetts and
New Hampshire) with banks in the same region that
did not offer these accounts (namely banks in New
Jersey, Connecticut, and Vermont). The profitability ratios are examined both before and after the
introduction of NOW accounts. If implicit rates are
less than competitive, and the explicit payment
allowed on NOW accounts is close to a competitive
rate, then the profitability of banks offering NOW
accounts should decline if implicit payments are less
than competitive. If the ratios remain roughly the
same, then the evidence favors the hypothesis that
implicit rates are competitive. Rush’s results can
generally be viewed as favoring the hypothesis that
implicit rates are competitive.
There are some additional problems that are common to Klein’s rate and the estimates in the other
two studies. Each estimate attempts to measure
the value that depositors place on free services obtained from the bank per additional dollar of deposits.
The cost to the bank of providing these services need
not be equivalent to the value placed on these services
by the depositor. In general the depositor would
prefer an explicit payment implying that these rates
are biased upward. However, explicit payments are
taxed while services not charged for aren’t. This
factor will bias the implicit rates in the opposite
direction. The sum of these offsetting effects is
unclear and will depend on individual preferences
and marginal tax rates.

As indicated in the preceding section all of the
various implicit rates contain interesting information,
but each suffers from a number of problems. The
question then remains, are the problems so large as
to make these estimates unproductive. In part this
For more detail concerning the payment for cash management services, see Simpson [11].



question can only be answered by examining their
explanatory power when used in studies of the demand for money. This is done in section IV. However, it may be useful to compare the measures
The comparison between all three rates is contained in table I and in figure 1. Column 1 of table I
contains Startz’s rate, RDDS; column 2 contains the
marginal rate calculated by Barro and Santomero,
RDDBS; column 3 displays the competitive rate
derived by Klein, RDDK; column 4 exhibits the
average annual dividend rate of shares of savings and
loan associations, RS; while column 5 displays the
4-6 month commercial paper rate, RCP. The time
period examined is 1954-68 since this is the period
over which the various rates overlap. Figure 1 is a
graph of each implicit rate allowing for easier comparison.
As can be seen from both table I and figure 1 the
levels of the rates are quite different, but the movements of the various rates over time are correlated.
The exact correlation is displayed in table II. The
information contained in table II indicates that all
three rates are highly correlated.

In order to evaluate the usefulness of each of the
three proxies, their explanatory power is compared
in a demand, for money equation over the period
1954-68. The following equation was estimated using
annual data.

w h e r e R D Dl = 0 , R D D2 = R D D S , R D D3 =
R D D B S , a n d R D D4 = RDDK. M1 is equal to
currency plus demand deposits and P is the GNP
deflator. In equation (3) real money demand is
expressed as a function of real transactions income,
which is approximated by real consumption,7 and the
Consumption was used as a scale variable since I believe
that it is more closely related to transactions income. In
Dotsey [6], it is found to be superior to GNP in explaining demand deposit behavior.
Also, many studies of
money demand use permanent income as a scale variable.
Since consumption is closely related to permanent income
one may also wish to interpret the equation in terms of
permanent income rather than transactions income. For
more detail see [6].

opportunity cost of holding money. Two opportunity
costs are used since different individuals may have
access to different rates. The opportunity costs are
expressed as differentials in interest rates and have
been entered in semilogarithmic form for the reasons
outlined in Friedman and Schwartz [7; p. 265].
Basically, this specification assumes that the absolute
level of opportunity costs is important in determining
the demand for money balances. This implies that a
doubling of the opportunity cost from l-2 percent
would have a smaller effect than the doubling of the
opportunity cost from 5-10 percent. In a log linear
model both changes would have an equivalent effect.
The results of the four regressions given in equation (3) are contained in table III. The effect of
including the implicit rate derived by Barro and
Santomero is especially striking. The standard error
of the regression declines by 38 percent, while the
presence of serial correlation is greatly reduced.

Table II




















Given the results of using Barro and Santomero’s
implicit rate, a possible interpretation of the serial
correlation in the regression that omits implicit rates
is that the regression is misspecified. The correlation
present in the errors occurs because the equation fails
to take into consideration an important variable that
influences the demand for money. 8
The implicit interest rate derived by Startz does
not seem to be a useful measure in explaining the
demand for money. Its addition actually reduces the
performance of the regression. On the other hand,
Klein’s competitive implicit rate improves the demand for money equation slightly. Of interest in
this latter case is the large change in the coefficients
on the interest rate variables from those in the other
three equations. Unfortunately, the manner in which
this rate is calculated makes it difficult to evaluate its
econometric performance. The derivation of Klein’s
rate makes the presence of spurious correlation possible, and since these effects are similar to the type
of effects expected in theory, it is generally difficult

to discriminate between the two.9 The nature of the
spurious correlation can be seen by examining the
first term on the right-hand side of equation (2),

in obtaining the level of demand deposits then there

and DD, and hence M1. For instance, if the measurement of demand deposits is greater than the actual

will be raised. This is indeed regrettable since a
competitive rate seems to be a reasonable approximation for an implicit rate, especially with respect to
corporate accounts.1 0
For a more detailed discussion, see Carlson and Frew
[5]. Friedman and Schwartz [7] also present an interesting discussion in footnote 46, pp. 270-74. Friedman and
Schwartz present evidence over a much longer sample
period,. where they look at data over peaks and troughs
of business cycles. Klein’s rate more accurately reflects
real rather than spurious effects in their money demand


When RS-RDDK is dropped from the third regression, the coefficient on RCP-RDDK drops dramatically,
and when RCP-RDDK is eliminated the coefficient on
RS-RDDK is insignificantly different from zero.

The regressions also were corrected for first order serial
correlation. Although the standard errors are greatly
reduced the general message is unchanged.

Table III


Equation 1

Equation 2

Equation 3

Equation 4






LN (Real



































t-statistics are in parenthesis.



In this article the value of incorporating an implicit
interest rate in money demand analysis has been
Specifically, three very different constructions have been investigated. While all three
are interesting, the rate derived by Barro and Santomero seems to be the most useful in the context of
analyzing the demand for M1. Although additional
information on the ways implicit interest is paid by
banks is desirable, the results obtained here indicate
that this variable merits updating. Klein’s rate, although it is probably a good proxy for interest implicitly earned by corporate customers (and may be a
good estimate for all depositors) is unfortunately
plagued by econometric problems that make interpreting its effect in regression equations difficult.
The rate derived by Startz is subject to a number of
procedural problems and did not prove to be very
useful in explaining the demand for money over the
rather short sample period studied in this article.
The general conclusion is that implicit rates, especially the approximation generated by Barro and
Santomero are important elements in determining
the demand for money. This being the case, these
rates will also be important in analyzing the effects
of current and future deregulation in the banking
industry. A detailed analysis of the effects of deregulation would be somewhat beyond the scope of this
study, but a limited discussion is germane to the main
thrust of the article.
In order to understand the ways in which deregulation has affected and will affect the behavior of
monetary aggregates, in particular M1, it will be
necessary to examine the rate of returns that new
transactions accounts yield relative to the rates im-


plicitly earned by demand deposits. This is because
it is this differential that constitutes the opportunity
cost of continuing to use a standard demand deposit
account. For instance, the 5¼ percent interest rate
paid on NOW accounts overstates the relative advantage of using a NOW account, since demand deposits
implicitly earn a rate of return greater than zero.11
Without considering implicit rates it is difficult to
understand why all consumer accounts did not switch
to NOW accounts almost immediately. For certain
types of depositors a NOW account may offer very
little if anything beyond that of a regular demand
Of course, considering only implicit rates in an
analysis of the differences between demand deposits
and newer types of transactions accounts would be too
limiting. There are many characteristics that distinguish one type of account from another. Minimum
or average balance requirements would be an example
of such a characteristic. It may also be that banks
offer different implicit rates to different types of
depositors. A deeper understanding of the demand
for money may require that different types of accounts be studied separately. Data limitations unfortunately prevent analysis at this level.
The point of this article is not to detract from the
importance of other features that determine the behavior of depositors, but to describe the effects that
implicit rates have on the demand for money. Although implicit rates are only one aspect that influence the choice between transactions accounts, there
are numerous reasons for believing that they are an
important aspect that require more attention in investigating the demand for money.
The analysis assumes that at the margin NOW accounts earn a much smaller implicit rate than standard
demand deposit accounts.


1. Barro, Robert J., and Anthony M. Santomero.
“Household Money Holdings and the Demand Deposit Rate.” Journal of Money, Credit and Banking,
4 (May 1972), 397-413.
2. Becker, William E. “Determinants of the United
States Currency-Demand Deposit Ratio.” The
Journal of Finance, 30 (March 1975), 57-74.
3. Boughton, J. M. “Subjective Prices and the Demand for Money.” Unpublished manuscript, IMF.
4. Boyd, John H. “Household Demand for Checking
Account Money.” Journal of Monetary Economics,
2 (January 1976), 81-98.
5. Carlson, John A., and James R. Frew. “Money
Demand Responsiveness to the Rate of Return on
Money: A Methodological Critique.” Journal of
Political Economy, 80 (June 1980), 498-607.
6. Dotsey, Michael. “The Effects of Cash Management Practices on the Demand for Demand Deposits.” Working Paper Federal Reserve Bank of
Richmond, 1983.

7. Friedman, Milton, and Anna J. Schwartz. Monetary Trends in the United States and the United
Kingdom. University of Chicago Press, 1982.
8. Klein, Benjamin. “Competitive Interest Payments
on Bank Deposits and the Long Run Demand for
Money.” American Economic Review, 64 (December 1974), 931-49.
9. Klein, Michael A. “The Implicit Deposit Concept:
Issues and Applications.” Economic Review, Federal Reserve Bank of Richmond (September/October 1978), 3-12.
10. Rush, Mark. “Comment and Further Evidence on
Implicit Interest on Demand Deposits.” Journal of
Monetary Economics, 6 (July 1980), 437-51.
11. Simpson, Thomas D. “The Market for Federal
Funds and Repurchase Agreements.” Staff Studies
106. Washington : Board of Governors of the
Federal Reserve System, 1979.
12. Startz, Richard. “Implicit Interest on Demand Deposits.” Journal of Monetary Economics, 5 (October 1979), 515-34.





To suppose that any increased issues of the [Central] Bank can have the effect of permanently
lowering the rate of interest . . . is to attribute a
power to the circulating medium which it can
never possess.
David Ricardo, 1811
I must confess my amazement at finding people
censure or praise the [Central] Bank for making
the rate of interest high or low, when the Bank
has no possible power to make it the one or the
John C. Hubbard, 1857

. . . the rate of interest . . . is determined by the

general conditions of demand and supply of real
capital; these lie outside the Central or any other
Bank’s control . . .
A. C. Pigou, 1927

. . . monetary policy . . . cannot peg interest rates
for more than very limited periods . . .
Milton Friedman, 1968

Among the more contentious issues in the continuing debate over monetary policy is the central
bank’s ability permanently to peg real interest rates.
Does the central bank really possess the power to
maintain rates indefinitely at any arbitrary level it
chooses? Or is the real rate basically determined by
nonmonetary factors such that attempts to hold it
below its equilibrium level via excessive monetary
growth will simply result in higher rates of inflation
and so higher nominal interest rates leaving the real
rate undisturbed?
The foregoing questions are no doubt familiar to
students of recent and current monetary policy. Not
so well-known, perhaps, is what earlier generations of
monetary scholars had to say about the feasibility of
interest-pegging policies. In an effort partially to
offset this deficiency and provide historical perspective, this article examines the opinion of leading


classical ( 1750-1870) and neoclassical (1870-1936)
economists regarding the ability of central banks to
control (real) interest rates. It shows that the
notion of interest rate pegging had already been
thoroughly criticized and largely discredited by the
early 1800s. Before doing so, however, it sketches
the basic outlines of the classical/neoclassical view
in order to demonstrate how individual writers contributed to it.
Essentials of the Classical/Neoclassical View
Essentially the position of the classical and neoclassical schools was that (real) rate pegging is impossible. 1 Like modern monetarists, they contended
that the central bank was largely powerless to permanently lower market interest rates and that its
attempts to do so would merely raise prices. This
conclusion derived from the classical notion that
interest rates are basically determined by productivity
and thrift-or more precisely by the marginal productivity of capital and society’s rate of time preference.2 Since monetary expansion does not affect
these real determinants, it cannot permanently alter
interest rates. To be sure, classical and neoclassical
writers recognized that the monetary authority could
temporarily lower its own loan (discount) rate,
thereby generating a gap between the latter rate and
the going rate of profit on capital (the equilibrium
rate of interest). But they argued that this gap
inevitably produces price increases that force the
bank rate back into equality with the equilibrium
With the notable exceptions of Thornton, Marshall, and
Fisher, classical and neoclassical writers typically did not
distinguish between real and nominal interest rates. They
implicitly assumed the expected rate of inflation to be
zero so that the two rates were one and the same.

On classical/neoclassical interest theory see Patinkin
[12, pp. 366-72, 630-33].



rate, thus rendering futile any attempts to peg the
former rate.
As for the mechanism or channels through which
this reaction occurs, classical/neoclassical economists
specified two, both involving the demand for and
supply of loanable funds and both assuming that new
money enters the economy through the loan market.
According to the first, a rise in the money supply
temporarily depresses loan rates via an expansion in
loan supply. At the same time, the monetary increase
generates an excess aggregate demand for goods in
the commodity market and so raises prices. And
since with rising prices more loans are required to
finance a given real quantity of business investment
projects, it follows that loan demands increase. Assuming prices rise in proportion to the money stock,
loan demands would rise in proportion to loan supply,
thereby restoring loan rates to their original level,
the going profit rate on capital. According to the
second mechanism, this effect works chiefly through
loan supply. In particular, as prices rise, more cash
is needed for hand-to-hand circulation. There occurs
a cash drain from the banks that diminishes bank reserves. To protect reserves from depletion, banks
(including the central bank) raise their loan rates, or
what is the same thing, contract their loan supply.
Either way the result is the same: interest rates
return to their former level and only prices change.
Since this self-correcting mechanism works automatically to restore real yields to their equilibrium
level, it follows that the central bank is powerless to
peg those rates.
Classical/neoclassical monetary theorists recognized only one situation in which the central bank
could permanently lower real interest rates. This was
the famous “forced saving” case in which inflationary
monetary policy could, because of a lag in the adjustment of wages to prices, transfer real income from
labor to capital thereby encouraging fixed capital
investment. The resulting higher rate of capital
formation lowers the marginal productivity of capital
and thus lowers equilibrium interest rates. This case,
however, was treated as a mere curiosum, a minor
exception to the rule that central banks are incapable
of permanently influencing interest rates. For the
most part, classical and neoclassical writers stressed
the powerlessness of central banks to peg interest
rates. This is especially evident in the work of Hume,
Smith, Thornton, Ricardo, and Mill-all of whom

saw the interest rate as a real variable immune to
monetary manipulation.
David Hume (1711-1776)
Hume was the earliest British classical economist
to present the essentials of the proposition that interest rates are immune to monetary control. He argued
(1) that the equilibrium rate is a real rather than a
monetary magnitude, (2) that one-time monetary
injections may temporarily lower the market rate
below its equilibrium level, (3) that the same monetary injections will raise prices, and (4) that the resulting price increases, via their effect on loan demands, will reverse the fall in the market rate and
restore it to its initial level, thereby frustrating all
attempts at interest rate control.
Regarding the first point, he declared that the equilibrium real interest rate is invariant with respect to
the size of the money stock. “It is in vain,” he said,
“to look for the cause of the [permanent] fall or rise
of interest in the greater or less quantity of gold and
silver” in circulation. [6, pp. 48-9] Monetary expansion, he said, does not alter the real characteristics
of the economy. It affects neither capital’s productivity nor society’s rate of time preference; therefore
it has no effect on the equilibrium rate. It merely
inflates equiproportionally both the equilibrium nominal return to capital and the money value of capital
itself, leaving their ratio-the rate of profit and hence
the equilibrium rate of interest-undisturbed.
Money having chiefly a fictitious [i.e., nominal]

value, the greater or less plenty of it is of no
consequence . . . . The same interest, in all cases,
bears the same proportion to the [capital] sum.
And if you lent me so much labour and so many
commodities; by receiving five per cent, you always
receive proportional labour and commodities, however represented . . . [6, p. 48]

It follows that “the rate of interest . . . is not derived
from the quantity” of money but rather from the real
forces of productivity and thrift. Thus, if we
. . . suppose, that, by miracle every man in Great
Britain should have five pounds slipt into his

pocket in one night; this would much more than

double the whole money that is at present in the
kingdom; yet there would not . . . be . . . any variation in the interest . . . . That [i.e., a fall in
interest] depends upon another principle; and must
proceed from an encrease of industry and frugality,
of arts and commerce. [6. p. 51]

Having described the invariance of the interest rate
with respect to monetary changes after all adjustments have occurred, Hume then described its be-



havior during the transitory adjustment period. With
respect to the self-correcting mechanism that restores
market rates to equilibrium after a monetary shock,
he argued as follows: New money typically enters
the circulation by way of loan. The resulting expansion of loan supply relative to loan demand temporarily lowers market rates. But the new money also
puts upward pressure on prices. And since with
rising prices more loans are needed to finance the
same level of real activity, it follows that loan demands rise. The rise in loan demands reverses the
initial fall in market rates and restores them to their
preexisting levels thereby frustrating attempts to keep
them low. That is, assuming that the new money is
initially concentrated in the hands of lenders,
The encrease of lenders above the borrowers sinks
the interest; and so much the faster, if those, who
have acquired those large sums, find . . . no method
of employing their money but by lending it at
interest. But after this new mass of gold and
silver has been digested, and has circulated through
the whole state, affairs will soon return to their
former situation . . . . The whole money may still be
in the state, and make itself felt by the encrease of
prices: But . . . [the resulting rise in loan demand
ensures that] the disproportion between the borrowers and lenders is the same as formerly, and
consequently the high interest returns. [6, p. 58]

It follows that expansionary monetary policy would
have no lasting effect on interest rates.
Adam Smith ( 1723-l 790)
Like Hume, Smith was instrumental in establishing
some key components of the proposition that central
banks cannot control interest rates. These components included (1) the concept of the interest rate
as a real variable determined by productivity and
thrift, (2) the notion that the equilibrium interest
rate reflects the real profit rate on capital and not the
abundance or scarcity of money, and (3) an explicit
denial that money growth lowers interest rates.
David Ricardo summarized Smith’s views succinctly.
It has been shewn incontrovertibly by that able
Writer, Dr. Adam Smith, that the rate of interest
for money is regulated by the rate of profits on
that part of capital only which does not consist of
circulating medium, and that those profits are not
regulated but are wholly independent of the greater
or lesser quantity of money which may be employed
for the purposes of circulation; that the increase of
circulating medium will increase the prices of all
commodities, but will not lower the rate of interest.
[15, pp. 25-6, quoted in 5, p. 105]


In support of the proposition that money growth does
not affect interest rates, Smith, according to Ricardo,
noted “that the discovery of the mines in America,
which so greatly increased the quantity of money, did
not lessen the interest for the use of it; the rate of
interest being regulated by the profits on the employment of capital,” and not by the quantity of money
“used to circulate its produce.” [17, p. 33]
Henry Thornton ( 1760-l 815)
The next economist to be considered is Henry
Thornton, the greatest of all classical monetary theorists, whose work unfortunately is not well-known.
He made seminal contributions to the theory of the
lender of last resort, to the analysis of velocity and
the demand for money, to the theory of the transmission mechanism linking money to nominal income,
to the Fisherine distinction between real and nominal
interest rates, to the purchasing power parity theory
of exchange rates, to the monetary approach to balance of payments and exchange rate analysis, to the
classical theory of international transfers, and to the
monetarist criticism of the real bills doctrine. Most
important, he constructed the basic analytical model
used by classical and neoclassical economists to
demonstrate the futility of policies aimed at interest
rate control.
His model consisted of three elements. First was
the distinction between the market (loan) rate of interest and the expected rate of profit on new capital
investment-this latter rate defined as the equilibrium to which the loan rate tends to conform. Second
was a loanable funds theory of interest rates according to which the market rate is determined by loan
demand and supply. Of these two determinants,
Thornton defined loan demand as the nominal value
of capital goods financed by borrowing and loan
supply as the sum of saving plus new money issued
by way of loan. A monetary expansion, he noted,
would increase loan supply and temporarily lower the
market rate. The third element of Thornton’s model
was an adjustment mechanism that worked to restore
the market rate to its equilibrium level following a
monetary shock. Consisting of a causal chain running
from money to prices to loan demand to market rates,
this mechanism, he argued, acts to reverse interest rate movements caused by changes in the monetary component of loan supply. Using his model,


Thornton was able to show that any divergence between the two rates owing to increases in the money
supply would be short-lived: such divergences would
automatically set in motion a process of rising prices
and increasing loan demands that would bid the loan
rate into equality with the equilibrium rate, thereby
frustrating all attempts at pegging.
Having applied his model to the problem of interest
rate control, Thornton mentioned two points largely
overlooked by his predecessors. First, he noted that
the interest-adjustment mechanism presupposes a
metallic monetary system in which gold reserve requirements and convertibility constraints exist to
limit money growth. These constraints ensure that
loan demands overtake loan supplies so that the market rate returns to its equilibrium level. He noted,
however, that no such constraints exist in inconvertible paper regimes. Consequently money, and hence
loan supplies, could expand without limit to accommodate loan demands at all rates below the equilibrium profit rate. Given the unlimited elasticity of
loan supply, loan demand increases cannot bid up
market rates. Therefore, permanent pegging is theoretically possible in this latter case.
While conceding the possibility of pegging under
inconvertible paper, Thornton considered it unlikely.
Such pegging, he noted, would be accomplished at
the cost of ever-rising prices. Assuming the authorities would find this cost intolerable, they would
abandon pegging and allow market rates to seek their
natural levels. In this case the responsibility for
avoiding inflation would provide the constraint necessary for the working of the interest-adjustment
Thornton’s second point was that interest control
policies could be successful if a lowering of the market rate induced a corresponding permanent reduction
of the equilibrium profit rate. Here was the first
mention of the forced saving doctrine. As stated by
Thornton, this doctrine holds that inflationary monetary policy can, because of a lag in the adjustment of
wages to prices, redistribute income from labor to
capital. Assuming capitalists’ propensity to save and
invest is higher than workers’, this redistribution
stimulates capital formation and lowers the marginal
productivity of capital and thus the equilibrium rate
of interest to the desired market rate. Having
stated this doctrine, however, Thornton paid it little
attention. He saw it as a trivial exception to the rule
that central banks cannot affect interest rates.

David Ricardo ( 1772-l 823)
Whereas Thornton acknowledged the theoretical
possibility of interest-rate pegging in the inconvertible
paper and forced saving cases, Ricardo categorically
denied that the central bank could permanently control market rates under any circumstances. He said:
I believe . . . that no amount of loans which the

Bank might make, and no degree of lowness of
interest at which it might choose to lend, would
alter the permanent rate of interest in the market.
Interest is regulated chiefly by the profits that

may be made by the use of capital; it cannot be
controlled by any bank [including the central
bank], nor by any assemblage of banks. [17, p.

He was even more emphatic on this point in his
Principles of Political Economy and Taxation
. . . the interest for money . . . is not regulated by

the rate at which the Bank will lend, whether it be
5, 4, or 3 per cent, but by the rate of profit which
can be made by the employment of capital, and
which is totally independent of the quantity, or of
the value of money. Whether a Bank lent one
million, ten millions, or a hundred million, they
would not permanently alter the market rate of
interest; they would alter only the value [i.e., purchasing power] of the money which they thus
issued. [14, pp. 363-64]

He reached this conclusion via the following route:
The rate of interest is determined by the abundance
or scarcity of real capital. Money is not real capital.
Hence its quantity cannot affect the interest rate. As
he put it in his famous essay on “The High Price of
Bullion and Depreciation of Bank Notes” (1811) :
. . . the rate of interest is not regulated by the

abundance or scarcity of money, but by the abundance or scarcity of that part of capital not consisting of money . . . . As the increase of bank notes
does not add to this species of capital . . . it cannot
. . . lower interest. [17, pp. 32, 36]

He conceded, however, that the central bank could
temporarily depress interest rates: But he stressed
the transcience of this effect : no central bank, despite
its best efforts, could prevent rates from eventually
returning to their real equilibrium levels. Said he:
I do not dispute, that if the Bank were to bring a
large additional sum of notes into the market, and
offer them on loan, but that they would for a time
affect the rate of interest . . . . but having done so
. . . the notes . . . would [not] be retained unemployed by the borrowers; they would be sent into
every market, and would everywhere raise the



prices of commodities, till they were absorbed in the
general circulation. It is only during the interval
of the issues of the Bank, and their effect on prices,
that we should be sensible of an abundance of
money; interest would, during that interval, be
under its natural level ; but as soon as the additional sum of notes . . . became absorbed in the
general circulation, the rate of interest would be
high, and new loans would be demanded with as
much eagerness as before the additional issues.
[17, p. 35]

In short,
Reduction or Increase of the Quantity of Money
always ultimately raises or lowers the Price of
Commodities; when this is effected, the Rate of
Interest will be precisely the same as before; it is
only during the Interval, that is, before the Prices
are settled at the new Rate, that the Rate of
Interest is either raised or lowered. [16, p. 445
quoted in 5, p. 481, n. 17]

Finally, he ridiculed the notion that the central
bank can peg interest rates at arbitrarily low levels.
To suppose that any increased issues of the Bank
can have the effect of permanently lowering the
rate of interest . . . is to attribute a power to the
circulating medium which it can never possess.
Banks would, if this were possible, become powerful
engines indeed. By creating paper money, and
lending it at three or two per cent under the
present market rate of interest, the Bank would
reduce the profits on trade in the same proportion;
and if they were sufficiently patriotic to lend their
notes at an interest no higher than necessary to
pay the expenses of their establishment, profits
would be still further reduced; no nation, but by
similar means, could enter into competition with us,
we should engross the trade of the world. To what
absurdities would not such a theory lead us!
Profits can only be lowered by a competition of
capitals not consisting of circulating medium. As
the increase of bank notes does not add to this
species of capital, as it neither increases our exportable commodities, our machinery, or our raw
materials, it cannot add to our profits nor lower
interest. [17, pp. 35-6]

John Stuart Mill (1806-1873)
The last classical economist to be considered is
J. S. Mill. His opinion of the central bank’s ability
to control interest rates via changes in the money
stock is summarized in the following passage:
The rate of interest, then, depends essentially and
permanently on the comparative amount of real
capital offered and demanded in the way of loan;
but is subject to temporary disturbances of various
sorts from increase and diminution of the circulating medium . . . [9, p. 647]

In other words, the central bank can exercise a tem16

p o r a r y3 but not a permanent influence on interest
rates since in the final analysis those rates are determined by real forces.
[H]ow great an error, then, it is to imagine that
the rate of interest bears any necessary relation
to the quantity or value of money in circulation.
An increase of the currency has in itself no [permanent] effect, and is incapable of having any
such effect, on the rate of interest . . . . It diminishes indeed the power of money to buy commodities, but not the power of money to buy money [i.e.,
to command an unchanged rate of interest]. [10,
p. 210]

Mill recognized only one exception-the forced
saving case-to the rule that central banks cannot
control interest rates. Like Thornton, he admitted
that an inflation-induced redistribution of real purchasing power from workers to capitalists would
permit income to be “converted into capital : and
thus, strange as it may appear, the depreciation of the
currency, when effected in this way, operates to a
certain extent as a forced accumulation” that lowers
equilibrium rates. [11, p. 118] But he thought this
case to be practically unimportant, ranking it among
the “anomalies in the rate of interest, which have not
been hitherto brought within the pale of exact
science.” [11, p. 114]
In short, Mill’s position was much the same as
Thornton’s. Like Thornton, he believed that, except
for the forced saving case, the central bank is largely
powerless to maintain market interest rates at any
arbitrary level and that its attempts to do so would
merely raise prices. This was on the grounds that
the equilibrium rate of interest is predominantly a
real (nonmonetary) phenomenon determined by productivity and thrift. As such, it is invariant with
respect to monetary expansion engineered by the
central bank. Thus any attempt to hold market rates
below that real equilibrium level via expansionary
monetary policy would simply produce a rise in
prices and a consequent increase in the demand for
Mill was quite explicit regarding these transitory effects.
A monetary expansion, he noted, can temporarily lower
market yields.

An increase . . . of currency issued by banks, tends,
while the process continues, to bring down or to
keep down the rate of interest. [9, p. 647]
But once the expansion ends (as it must if the authority
is to honor its obligation to maintain convertibility and/or
price stability) the rate of interest returns to its original
level. There it

. . . bears no . . . relation to the quantity . . . of
the money in circulation. The permanent amount of
the circulating medium, whether great or small,
affects only prices; not the rate of interest. [9, p.


loans (as well as a drain on cash reserves) which
would force the market rate back to its initial equilibrium level. As viewed by Mill, this rate-equilibrating
mechanism would always work provided there existed
some absolute constraint (e.g., positive cash reserve
ratios, the monetary authority’s unwillingness to
tolerate inflation forever) on the money stock. Given
these conditions, he held that interest pegging was
impossible-the essence of the classical view.
Bankers’ Opinion
The foregoing classical view was not confined to
the classical economists themselves. It was also held
by influential 19th century British bankers, whose
views carried greater weight in financial circles than
those of the economists of the time. A prime example
is James Morris who, according to Elmer Wood in
his scholarly English Theories of Central Banking
Control, 1819-1858, contended that the central bank
“can never keep interest rates unnaturally low for
any length of time.” [21, p. 138] The same opinion
was voiced by William Cotton who, according to
Wood, held that the market rate in any nation “is
regulated by the general rate all over the world” such
that “if the [Central] Bank were to keep the rate
unnaturally low the pressure on it would soon become
so great as to require it to raise the rate.” [21, p.
138] Even more emphatic was Samuel Jones Loyd
(Lord Overstone) who declared that the directors of
the “Bank of England have no more power of raising
the rate of discount than you or I have; they must
conform” to the rate dictated by real forces. [quoted
in 21, p. 139] Perhaps the strongest statement of
the central bank’s impotence in regard to interest rate
control came from J. G. Hubbard (Lord Addington).
Said he, “I must confess my amazement at finding
people censure or praise the Bank for making the
rate of interest high or low, when the Bank has no
possible power to make it the one or the other.”
[quoted in 21, p. 139] These quotations indicate
that the classical view was not restricted to an esoteric circle of academic scholars but rather had
achieved a wider recognition by the middle of the
19th century.
Neoclassical Views
Given the widespread acceptance of the classical
view, it is hardly surprising to find it repeated in the
neoclassical ( 1870-1936) monetary literature. Indeed, it is a central theme of the writings of such

well-known neoclassical theorists as Eugen von
Bohm-Bawerk, Knut Wicksell, Alfred Marshall,
Irving Fisher, and Arthur C. Pigou. Like their
classical predecessors, these writers contended that
the equilibrium rate is a real magnitude to which the
market rate normally conforms; that a discrepancy
between the two rates will result in a cumulative rise
in prices; and that this price increase itself will
eliminate the rate disparity by raising loan demands
and/or reducing loan supplies, thereby bidding the
market rate into equilibrium. The first neoclassical
to employ these propositions in a demonstration of
the futility of interest-pegging policies was BohmBawerk.
Eugen von Bohm-Bawerk (1851-1914)
Eugen von Bohm-Bawerk, the celebrated Austrian
capital theorist and co-founder of the Austrian School
of economics, enunciated the neoclassical concept of
the interest rate as a real phenomenon immune to
monetary control. Said he:
The level of the interest rate prevailing in a
country does not in the long run depend on whether
that country has a large volume of coins or other

types of money, but on whether it is rich in real

capital, in stored-up products available for produc-

tive investment or for lending. [1, quoted in 7,
p. 129]

He admitted, however, that, because monetary injections enter the system via bank loan expansions,
. . . the stock of money, taking this term quite
literally, does exert a certain [temporary] influence
on the movements of the interest rate-an influence which, although not profound, is very conspicuous and therefore often overestimated, especially
by the layman. [1, quoted in 7, p. 129]
But he insisted that this influence would be shortlived owing to the effect of money on prices and
prices on loan demands. In his words:
. . . the excess quantity of money, to the extent that
it pours into the channels of the commodity markets, will in a well-known fashion reduce the purchasing power of money. Money prices of all
commodities-and, thus, prices of real capital goods

-will rise; and ultimately more units of money
than previously will be required to transfer the
same amount of real capital goods. Once matters
have come to this point, the increased supply of
money which initially pressed on the market as
excess supply will be completely absorbed by the
demand for money capital which rises for the above
reason. Eventually the disturbed equilibrium between supply and demand will be restored, and the
normal interest rate corresponding to the actual
supply of real capital will also be re-established.
[1, quoted in 7, pp. 129-30]



Here are the standard ingredients of the neoclassical
view: the distinction between equilibrium and market rates, the notion of the former as a real magnitude
to which the latter eventually conforms, and the concept of price-induced shifts in loan demand as the
equilibrating mechanism that frustrates attempts at
interest rate control.
Alfred Marshall (1642-1924)

Irving Fisher, the celebrated American quantity
theorist, monetary reformer, and pioneer econometrician, shared Marshall’s views on interest rate control.
Like Marshall, he denounced the notion that expansionary monetary policy permanently lowers market
rates. This notion, he said,
. . . is fallacious, and the fallacy consists in for-

The foregoing ideas were likewise employed by
Alfred Marshall. He concluded that interest rates are
independent of the money supply and are therefore
resistant to monetary control. More precisely, he
contended that the average rate on short-term loans
(“the rate of discount”) is governed by the average
rate on long-term loans which in turn is determined
by the profit rate on capital. Since the profit rate
itself is determined by the real forces of productivity
and thrift, it follows that
. . . the supply of gold [and by implication the
stock of paper money as well] exercises no permanent influence over the rate of discount. The
average rate of discount permanently is determined
by the profitableness of business. All that the
influx of gold does is to make a sort of ripple on
the surface of the water. The average rate of
discount is determined by the average level of
interest in my opinion, and that is determined
exclusively by the profitableness of business, gold
and silver merely acting as counters with regard
to it. [8, p. 41]
In line with this reasoning, he concluded that currency injections cannot keep interest rates low. For
. . . the increase of currency goes . . . to the banking
centres; and, therefore, it increases the willingness
of lenders to lend in the first instance, and lowers
discount . . . it afterwards raises prices, and,
therefore, tends to increase discount. This latter
movement is cumulative . . . . Thus, a fall in the
purchasing power of money tends, after a while, to
raise the rate of discount as well as the rate of
interest on long investments. [8, p. 274]
That is, while increases in the money stock can initially lower market rates and cause them to deviate
from the equilibrium rate, such deviations are inherently short-lived. For the resulting cumulative rise in
prices and loan demands will invariably restore market rates to their original levels.
Since moneyinduced falls in interest rates are self-reversing in
character, it follows that rate-pegging policies will
be ineffective.

Irving Fisher ( 1867-l 947)

getting that plentiful money [by raising prices and
thus the loan requirements of borrowers] ultimately raises the demand for loans just as much
as it raises the supply, and therefore has just as
much tendency to raise interest as to lower it. [3,
p. 356]

In short, falls in the interest rate caused by monetary
expansion are inherently self-reversing because
The inflation of the currency [raises prices and so
the need for borrowing and thus] pulls interest up
on the [loan] demand side as hard as it pulls it
down on the supply side. [3, pp. 357-58]

The result is an equiproportional rise in loan demand
and supply that leaves the interest rate unchanged.
To illustrate, he presented a hypothetical example
of a doubling of the money stock in which the following sequence occurs : First, the new money enters the
economy through’ the loan market, thereby doubling
the supply of loans and lowering interest rates. The
new money is then spent on the fixed full capacity
level of real output, thereby doubling prices. Faced
with rising prices, businessmen require double the
amount of loans just to finance the same level of real
activity. The result is a doubling of the demand for
loans that puts upward pressure on interest rates.
Noting that the increased loan demand reverses the
interest-depressing effect of the initial doubling of
loan supply, Fisher concluded that
. . . in the end, doubling the amount of money will

not affect the rate of interest. It will simply affect
the amount of money lent and borrowed. [3, p. 357]

He also noted that this conclusion, namely “that an
inflation of the currency does not affect the rate of
interest,” [3, p. 359] strictly holds for one-time but
not continuous increases in the money stock. For if
the inflationary increase is continuous, it will come
to be expected and these expectations will be incorporated into nominal rates. In this case, the monetary authority, far from keeping nominal interest
rates low, cannot prevent them from exceeding their
original level.


Knut Wicksell (1851-1926)
Like Marshall and Fisher, Knut Wicksell asked if
there exist “limits . . . which restrict the power of the
[central] banks” to peg market rates below their real
equilibrium levels. [19, p. 111 quoted in 12, p. 591]
Like them he answered in the affirmative. But
whereas they appealed to the effect of money-induced
price increases on loan demands to explain the futility
of interest-pegging policies, he stressed the impact of
prices on metallic reserves. More precisely, he argued
that the price increases generated when loan rates
are arbitrarily held below their natural (equilibrium)
levels would, in a metallic monetary system, precipitate internal drains of gold into hand-to-hand circulation, thereby diminishing bank reserves. Said he,
“where there are no [bank] notes of small denomination and where metallic money is used in business,
then on this assumption [of the continuous rise in
prices] the increased demand for gold for internal
business would soon empty the bank’s vaults.” [20,
p. 189 quoted in 12, p. 591] To protect their reserves
from depletion, banks (including the central bank)
raise their loan rates, or what is the same thing,
contract their loan supply. Either way, rates return
to their natural equilibrium levels, contrary to attempts to peg them. In this manner, the need to
maintain gold reserves limits the central bank’s influence over interest rates.
Wicksell of course acknowledged that the gold
reserve constraint would not exist in an inconvertible
paper regime. In this case, the authority theoretically
would be free to peg rates via unlimited money
growth. But he contended that in these circumstances
another constraint would rule, namely the obligation
to maintain price stability. Faced with this responsibility, the authority would be forced to abandon pegging and let interest rates gravitate to their natural
equilibrium levels.
Wicksell also acknowledged the forced saving exception discussed earlier in this article. That is, he
conceded that pegging would work provided inflation
itself generated, via the forced saving route, sufficient
capital formation to lower the marginal productivity
of capital and thus the natural rate of interest to the
target loan rate.
Arthur Cecil Pigou (1877-1959)
Undoubtedly the clearest statement of the proposition that central banks cannot control interest rates

came from the Cambridge economist, A. C. Pigou.
According to Pigou, that proposition asserts (1) that
real factors determine the equilibrium rate on longterm loans, (2) that interest arbitrage ensures that
this long-term rate governs all short-term rates
including the central bank’s discount rate, and (3)
that this means that even the discount rate is determined by conditions outside the central bank’s control.
The rate of discount is tied up to the rate of
interestmoney rate-on long loans; this rate, it is
argued, is determined by the general conditions of
demand and supply of real capital; these lie outside
the Central or any other bank’s control; and,
therefore, though, no doubt, on occasions for a little
while a strong Central Bank could hold its discount
rate above or below the rate for long loans (with
due allowance for differences of risk), attempts to
do this for any length of time must lead to a
transfer of borrowings between the long and short
loan markets, and so defeat itself. Hence, it is
argued, the Central Bank, despite its apparent
autonomy, is in fact merely a medium through
which forces wholly external to it work their will.
Though, that is to say, in determining the discount
rate, the voice is the voice of the bank, the hands
are not its hands. [13, p. 251]

This of course is not to deny that the central bank
can temporarily lower the discount rate below’ its
equilibrium level. But it does mean that the resulting
inflationary rise in money, prices, loan demands, and
nominal long-term yields will compel the central bank
to reverse the rate reduction. It therefore follows
. . . if the money rate of discount is altered at the
volition of the banks, just those associated changes
which have been described . . . must take place,
and must be carried to the point at which the real
rate of discount is equated (with the proper allowances) to the real rate of interest on long loans;
this real rate being throughout determined by conditions outside the bankers’ control. [13, p. 253]
In the final analysis, then, the central bank has no
choice but to let the discount rate conform to the
equilibrium rate. Pigou saw but one exception to
this rule, namely the forced saving case.
Milton Friedman
The classical/neoclassical notion of the inability of
the central bank to exercise permanent control over
interest rates persists today in the work of Milton
Friedman. The monetary authority, he says, “cannot peg interest rates for more than very limited
periods.” [4, p. 5] To show why this is so, he



distinguishes between the first-round “liquidity” or
“portfolio” effect of money growth on interest rates
and the subsequent “income and price level” and
“price expectation” effects. The liquidity effect refers
to the initial fall in interest rates caused by the monetary expansion. This expansion generates an excess
supply of money which people attempt to eliminate
by purchasing securities, thereby bidding up their
prices and lowering their yields. The income and
price level effects refer to the expansionary influence
of money growth on prices and nominal income,
which tend to reverse the initial decline in interest
rates. These two effects, of course, correspond to the
interest-lowering loan supply and interest-raising
loan demand effects stressed by the classical/neoclassical school. Finally, Friedman’s price expectations effect refers to the premium for expected
inflation that gets incorporated into nominal rates
and raises them above their initial level. Taken
together, these effects ensure that real rates inevitably
return to their equilibrium levels, regardless of the
actions of the monetary authority. Together, they
“explain why monetary policy cannot peg interest
rates.” [4, p. 7]
Concluding Comments
This article has sampled the opinion of leading
classical and neoclassical monetary theorists regard-


ing the central bank’s inability to permanently peg
interest rates. In so doing the article has no doubt
overlooked other economists who held similar views.
For example, nothing was said about Gustav Cassel,
who argued that a central bank faced with the responsibility for monetary and price level stability has no
choice but to set the bank rate at the exogenously
given equilibrium (natural) rate.
Nevertheless, the evidence presented is sufficient
to provide strong support for the main contention of
the article, namely that a central theme of the classical
and neoclassical monetary literature was that the
central bank is largely powerless to peg interest rates
and that its attempts to do so would merely change
the level of prices. Of course the mere dominance
of this view throughout 200 years of mainstream
monetary theorizing does not establish its validity.
But it does raise questions about the origins of the
opposing interest-pegging view. For whatever else
one may say about that alternative view, one cannot
claim that it derives from the economists quoted
above. In short, proponents of interest-pegging policies cannot draw support from the mainstream monetary tradition established by classical and neoclassical
writers. On the contrary, interest-pegging policies
are incompatible with this tradition.


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