Wicksellian monetary theory was widely accepted in the period before Keynes’ General Theory, and indeed Keynes himself accepted the natural rate of interest in the Treatise on Money.
The real natural rate of interest lies at the heart of Wicksell’s version of loanable funds theory, and links Wicksell’s capital theory with his monetary theory (Rogers 1989: 22). Wicksell’s monetary theory was an attempt to extend the quantity theory to an economy with credit money and loans (Rogers 1989: 23).
Wicksell’s theory of capital was in turn developed from the work of Jevons and Böhm-Bawerk (Rogers 1989: 27).
The concept of capital can be divided into two ideas:
(1) real capital, or the physical goods themselves, e.g., machines, tools, or raw materials, orReal capital in sense (1) can be measured in technical units, but that would mean that there would be as many technical units as there are types of capital goods (Rogers 1989: 28).
(2) capital defined in terms of a sum of exchange value (or in monetary terms). (Rogers 1989: 27).
But in order to calculate the rate of interest (the return on capital), capital has to be measured in monetary terms.
“Apart from pointing out the technical necessity of defining capital in value terms, Wicksell also suggests that it is necessary for theoretical reasons; namely, that in equilibrium the rate of interest must be the same on all capital. This condition is, of course, the classical condition of long-period equilibrium defined in terms of a uniform rate of return on all assets. It is the notion of equilibrium employed by Wicksell to define the natural rate of interest. To define such an equilibrium, however, capital must be treated as a mobile homogeneous entity so that it may move between sectors to equalize the rate of interest/profit. Capital defined as value capital (financial capital) can fulfil this role but capital defined in technical or quantity terms cannot.” (Rogers 1989: 28).Wicksell consequently argued that all capital goods can be regarded as “saved up labour and land” (Rogers 1989: 29).
When the money rate of interest at which demand for investment credit and the monetary supply of savings is equal, there is a monetary equilibrium rate. And, when this monetary equilibrium rate is also equivalent to the expected yield on new capital, then the money rate of interest and the real Wicksellian natural rate of interest are equal (Rogers 1989: 39).
Rogers argues that the Cambridge capital critique applies to Wicksell’s theory of capital, and that it has proven that Wicksell’s natural rate of interest is untenable outside a purely abstract one-commodity world (Rogers 1989: 22).
Rogers reviews the Cambridge capital controversy (Rogers 1989: 30–39), and notes the problems with the aggregative (Wicksellian) neoclassical production function (Rogers 1989: 30–32).
In essence, the major issues raised by the Cambridge Capital controversy relevant here are as follows:
(1) the problems with the treatment of capital in the neoclassical production function Q = f(K,L), and the circularity involved in defining the quantity of capital K, when to determine K one needs to know the rate of interest, but to determine the rate of interest one needs to know the value of capital K (Rogers 1989: 31). The upshot is that K cannot be an exogenous variable in the production function.Rogers points to three modern neoclassical responses to the Cambridge capital controversy, as follows:
(2) it is not possible, as noted above, to define the Wicksellian natural rate outside of a one commodity world (Rogers 1989: 32);
(3) the issue of reverse capital deepening, and
(4) capital reswitching (Rogers 1989: 32).
(1) those neoclassical economists who accept the critique and use an alternative neo-Walrasian analysis for general equilibrium theory that is not subject to the Cambridge capital critique, but that nevertheless has insolvable problems of its own (Rogers 1989: 34–35);Now the Classical loanable funds model of interest is supposed to relate how interest in a monetary economy still reflects the real forces of productivity and thrift (Rogers 1989: 40).
(2) those neoclassical economists who use a methodological defence of the neoclassical production function and Wicksellian general equilibrium theory applied to a one commodity world, which is supposed to be a useful pedagogical tool or “parable” teaching fundamental ideas of neoclassical interest theory, although it is untrue that such an unrealistic and empirically irrelevant model has any great lessons to teach (Rogers 1989: 34).
(3) those neoclassical economists who simply accept the neoclassical production function “on faith” (Rogers 1989: 33, n. 7).
But in a monetary economy the act of saving money does not necessarily reflect real saving (Rogers 1989: 42).
The only viable model in which the Wicksellian neoclassical interest theory is possible is one which assumes a one commodity world where that single commodity can function either a capital good or a consumption good (Rogers 1989: 32, n. 6).
The natural rate can only be defined in a one commodity world, but not in a world with heterogeneous capital goods (Rogers 1989: 32, 43). The consequence is that only the monetary rate of interest in the loanable funds model is left after the untenable natural rate is cut out, and that the money rate of interest is cut free of the real forces of productivity and thrift (Rogers 1989: 43).
Rogers, C. 1989. Money, Interest and Capital: A Study in the Foundations of Monetary Theory. Cambridge University Press, Cambridge.