DEFINITION of 'Gibson's Paradox'

Gibson's paradox is economic observation made by British economist Alfred Herbert Gibson that points to the positive correlation between interest rates and wholesale prices. The findings are a paradox because it is contrary to the view generally held by economists at the time, which was that interest rates were correlated to the rate of inflation.

BREAKING DOWN 'Gibson's Paradox'

While Gibson was the first to note this paradox, J.M. Keynes was the first to give the observation a name. In his research, which he discusses in "A Treatise on Money," interest rates were highly correlated to wholesale prices but had little correlation to the rate of inflation. In this paradox, interest rate movements are connected to the level of prices, not the rate of change in prices.

The foundation of Gibson's paradox is 200 years of empirical evidence gathered by Gibson, dispelling the theory that interest rates are correlated with the rate of inflation. His theory showed that interest rates are instead correlated with the wholesale price level. It is a paradox because there is no satisfactory explanation for it, even though the evidence is unequivocal. Keynes was among the first economists to accept Gibson's findings, writing, "The Gibson Paradox is one of the most completely established empirical facts within the whole field of quantitative economics." At the time, most economists dismissed it, preferring the quantitative theory of money, which suggests that the correlation exists between changes in the level of price inflation and interest rates.

The Relevance of Gibson's Paradox Today

The relevance of Gibson's paradox in modern economics is being challenged because the gold standard, which was the basis of the correlation, no longer exists. Instead, the central banks determine monetary policy through fiat methods that dictate the level of interest rates. Central bankers apply standard monetary theory to use interest rates as tool to manage inflation, believing that the correlation does exist.

Under Gibson's paradox, the correlation between interest rates and prices was a market-driven phenomenon, which can't exist when interest rates are artificially linked to inflation through central bank intervention. During the period Gibson studied, interest rates were set by the natural relationship between savers and borrowers to balance supply and demand. Monetary policies over the last several decades have suppressed that relationship.

There have been several attempts by economists to solve Gibson's paradox, but as long as the relationship between interest rates and prices remains artificially delinked, there may not be enough interest by today's macroeconomists to pursue it any further.

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