David Ricardo on the Natural Rate of Interest

Both Blaug (1992: 126) and King (2013: 123) point out that a market rate of interest and some kind of “natural” rate of interest can be found in David Ricardo’s On the Principles of Political Economy and Taxation.

I quote from the 3rd edition of 1821:

“The rate of interest, though ultimately and permanently governed by the rate of profit, is however subject to temporary variations from other causes. With every fluctuation in the quantity and value of money, the prices of commodities naturally vary. They vary also, as we have already shewn, from the alteration in the proportion of supply to demand, although there should not be either greater facility or difficulty of production. When the market prices of goods fall from an abundant supply, from a diminished demand, or from a rise in the value of money, a manufacturer naturally accumulates an unusual quantity of finished goods, being unwilling to sell them at very depressed prices. To meet his ordinary payments, for which he used to depend on the sale of his goods, he now endeavours to borrow on credit, and is often obliged to give an increased rate of interest. This, however, is but of temporary duration; for either the manufacturer's expectations were well grounded, and the market price of his commodities rises, or he discovers that there is a permanently diminished demand, and he no longer resists the course of affairs: prices fall, and money and interest regain their real value. If by the discovery of a new mine, by the abuses of banking, or by any other cause, the quantity of money be greatly increased, its ultimate effect is to raise the prices of commodities in proportion to the increased quantity of money; but there is probably always an interval, during which some effect is produced on the rate of interest.” (Ricardo 1821: 349–350).

So though affected by other factors, the money rate of interest is ultimately determined “by the rate of profit.”

Ricardo is adamant that the rate of profit is what fundamentally determines the money interest rate:

“M. Say allows, that the rate of interest depends on the rate of profits; but it does not therefore follow, that the rate of profits depends on the rate of interest. One is the cause, the other the effect, and it is impossible for any circumstances to make them change places.” (Ricardo 1821: 353, n.).

In Ricardo’s The High Price of Bullion (1810), an earlier work, he had already given a similar statement of what determines the money rate of interest:

“It is contended, that the rate of interest, and not the price of gold or silver bullion, is the criterion by which, we may always judge of the abundance of paper-money; that if it were too abundant, interest would fall, and if not sufficiently so, interest would rise. It can, I think, be made manifest, that 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.” (Ricardo 1810: 43).

So Ricardo though that the money rate of interest was determined by a real factor: the rate of profit on capital (King 2013: 123).

Ricardo even speaks of the money interest rate being driven below its “natural” level by excessive money supply increases:

“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. The same effects would follow from the discovery of a hidden treasure of gold or silver coin. If the amount were large, the Bank, or the owner of the treasure, might not be able to lend the notes or the money at four, nor perhaps, above three per cent.; but having done so, neither the notes, nor the money, would be retained unemployed by the borrowers; they would be sent into every market, and would every where 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 or of money became absorbed in the general circulation, the rate of interest would be as high, and new loans would be demanded with as much eagerness as before the additional issues.” (Ricardo 1810: 46–47).

There also appear to be two letters where Ricardo discusses the “natural” rate of interest in relation to the money rate, but I have not yet been able to read them:

(1) a letter to Pascoe Grenfell on the 27 August 1817, and

(2) a letter to Thomas Malthus on the 21 October, 1817.

BIBLIOGRAPHY
Blaug, Mark. 1992. The Methodology of Economics, or, How Economists Explain (2nd edn.). Cambridge University Press, Cambridge, UK.

King, John Edward. 2013. David Ricardo. Palgrave Macmillan, Basingstoke, UK.

Ricardo, David. 1810. The High Price of Bullion: A Proof of the Depreciation of Bank Notes (2nd edn.). John Murray, London.

Ricardo, David. 1821. On the Principles of Political Economy and Taxation (3rd edn.). John Murray, London.

Smithin, John N. 2003. Controversies in Monetary Economics (rev. edn.). Edward Elgar, Cheltenham, UK and Northhampton, MA.