Gibson's paradox is the observation that the rate of

interest In finance and economics, interest is payment from a borrower or deposit-taking financial institution to a lender or depositor of an amount above repayment of the principal sum (that is, the amount borrowed), at a particular rate. It is distinct ...

and the general level of prices are positively correlated. It is named for British economist Alfred Herbert Gibson who noted the correlation in a 1923 article for ''Banker's Magazine''. The correlation had been noted earlier by

Thomas Tooke Thomas Tooke (; 28 February 177426 February 1858) was an English economist known for writing on money and economic statistics. After Tooke's death the Statistical Society endowed the Tooke Chair of economics at King's College London, and a Tooke ...

. The term was first used by

John Maynard Keynes John Maynard Keynes, 1st Baron Keynes, ( ; 5 June 1883 – 21 April 1946), was an English economist whose ideas fundamentally changed the theory and practice of macroeconomics and the economic policies of governments. Originally trained in ...

, in his 1930 work, ''

A Treatise on Money ''A Treatise on Money'' is a two-volume book by English economist John Maynard Keynes published in 1930. Summary of the Work In the ''Treatise'' Keynes drew a distinction between savings and investment, arguing that where saving exceeded invest ...

''. It was believed to be a paradox because most economic theorists predicted that the correlation would be negative. Keynes commented that the observed correlation was "one of the most completely established empirical facts in the whole field of quantitative economics." The

Quantity Theory of Money In monetary economics, the quantity theory of money (often abbreviated QTM) is one of the directions of Western economic thought that emerged in the 16th-17th centuries. The QTM states that the general price level of goods and services is directly ...

predicts that a slower money-growth creates slower price-rise. In addition, slower money-growth means slower growth of

loanable funds In economics, the loanable funds doctrine is a theory of the market interest rate. According to this approach, the interest rate is determined by the demand for and supply of loanable funds. The term ''loanable funds'' includes all forms of credit, ...

and thus raises interest rates. If both these premises are true, slower money-growth should mean lower prices and higher interest rates. However, Gibson observed that lower prices were accompanied by a drop—rather than a rise—in interest rates. This is the

paradox A paradox is a logically self-contradictory statement or a statement that runs contrary to one's expectation. It is a statement that, despite apparently valid reasoning from true premises, leads to a seemingly self-contradictory or a logically u ...

that needs to be explained. For instance, in the 1873-96 depression, prices fell considerably while interest rates remained low. Economist S.B. Saul says that

Alfred Marshall Alfred Marshall (26 July 1842 – 13 July 1924) was an English economist, and was one of the most influential economists of his time. His book '' Principles of Economics'' (1890) was the dominant economic textbook in England for many years. I ...

explained the paradox by saying that other factors might have been at play: a peace dividend and improving international system of banking and finance. Economists generally thought that interest rates were correlated to the rate of inflation, whereas Keynes' findings contradicted this view. During the period of

gold standard A gold standard is a monetary system in which the standard economic unit of account is based on a fixed quantity of gold. The gold standard was the basis for the international monetary system from the 1870s to the early 1920s, and from the la ...

, he concluded that interest rates were correlated to the general price level, and not the rate of change in the prices. In fact, he thought that interest rates were highly correlated to the

wholesale price index The Wholesale Price Index (WPI) is the price of a representative basket of wholesale goods. Some countries (like the Philippines) use WPI changes as a central measure of inflation. But now India has adopted new CPI to measure inflation. However, ...

rather than the rate of inflation.

Citations

References

* * * * *http://www.investopedia.com/terms/g/gibsonsparadox.asp Monetary economics Paradoxes in economics Gold standard {{macroeconomics-stub