Alfred Marshall’s Interest Rate Theory

We can start with Alfred Marshall’s statement on 19 December 1887 to the British “Royal Commission on the Value of Gold and Silver” (edited for clarity):

[sc. Question:]“9651. The evidence that has been put by some witnesses before us has been intended to show that so far from any connexion being traceable between plentiful money and a low rate of discount and a plentiful supply of the precious metals, the evidence was just the other way?

[sc. Marshall’s answer:] Oh yes, that is certainly true as regards permanent results; the supply of gold 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.”
(Final Report of the Royal Commission Appointed to Inquire into the Recent Changes in the Relative Values of the Precious Metals; With Minutes of Evidence and Appendixes. Eyre and Spottiswoode, London, 1888. p. 4).

The “rate of discount” is Marshall’s expression for the money rate of interest. But, for Marshall, in the long-run the money rate of interest is determined by the “real” rate of interest, which is in turn determined by the demand and supply of real capital goods (Bridel 1987: 38): the “real” rate concept is analogous to Wicksell’s natural rate of interest.

But of course, for Marshall, variations in supply of gold can cause short-run changes in the money rate of interest.

In fact, Marshall saw four factors that could influence the money rate of interest, as follows:

(1) changes in the supply and demand for real capital;

(2) changes in the supply of commodity money;

(3) changes in the supply of money available for lending in the banking system, and

(4) the influence of speculators on financial asset markets (Bridel 1987: 38).

If the supply of gold increases, for example, then this will induce excessive demand for real capital goods and price inflation, according to Marshall (Bridel 1987: 41), and if there is an expectation of further prices rises there might be a cumulative process of inflation as further investment occurs (Bridel 1987: 41–42). This process is a short-run phenomenon. Eventually banks will raise money rates of interest and a new equilibrium will be reached as money rates rise to equal the long-run “real” rate (the functional equivalent of the natural rate) (Bridel 1987: 42).

Bridel (1987: 43) argues that Marshall missed the idea of “forced saving” and the latter insights of Keynes in the Treatise on Money (1930), that a contraction of consumption induced by forced saving lowers the marginal productivity of capital and hence lowers the natural rate of interest.

Nevertheless, Marshall’s interest theory is clearly a precursor to the loanable funds theory (Bridel 1987: 44).

BIBLIOGRAPHY
Bridel, Pascal. 1987. Cambridge Monetary Thought: The Development of Saving-Investment Analysis from Marshall to Keynes. Macmillan, Basingstoke.

Final Report of the Royal Commission Appointed to Inquire into the Recent Changes in the Relative Values of the Precious Metals; With Minutes of Evidence and Appendixes. Eyre and Spottiswoode, London, 1888.