five years, the lender of a five-year loan would receive each year $50, having a purchasing power successively 1, 2, 3, 4, and 5 per cent greater than the same sum had at the making of the loan; and at the end of the five years would collect the principal, having a purchasing power 5 per cent greater. The lender, on his part, would have to pay interest and re pay the principal in a money that is to be obtained only in exchange for a larger sum of goods than that which could be bought with each dollar that he borrowed. This means that, with individual exceptions, creditors generally gain and debtors lose by falling prices.
But this is fully true only in respect to loans already made. For, just to the extent that such a movement of prices comes to be more or less regularly in the same direction, both bor rowers and lenders are able to take it into account, and, as experience shows, do take it into account.1 When prices fall men become more eager to sell wealth, to lend the pro ceeds, and more reluctant to borrow for investment at the prevailing rate of interest and at the prevailing prices. There is an incentive to divest one's self of ownership (e. g., by selling stocks) and to become a lender (e. g., by buying bonds). This whole situation is reversed in a period of ris ing prices. The result is that the rate of interest in any long continued period of falling prices (such as from 1873 to 1896) has a trend downward and in a period of rising prices (such as from 1897 to 1915) has a trend upward. This movement of readjustment would not go on indefinitely, even if the same trend of prices continued; for in the strict theory of the case the adjustment would be complete when the in terest rate had changed by just the amount of the annual change in the level of prices. For example, if 5 per cent is the static normal rate of interest, then when prices are fall ing 1 per cent each year, the adjusted rate of interest would be 4 per cent ; and when prices were rising 1 per cent each 6 Mention was made in Vol. I, of the prospect of profit as affecting the motives of commercial borrowers; e. g., pp. 298, 335, 348, 495.
year, the adjusted rate of interest would be 6 per cent. Such adjustments serve to some extent to neutralize the effects of changes in the standard of deferred payments as far as concerns new loans made in view of just such a change and in expectation of its continuance. But no one can foresee exactly, and most persons take little account of, such a change until it has continued for several years in the same direction. The adjustment is therefore never very prompt or very exact. In some years the general level of prices has risen more than 5 per cent, or more than enough to offset the entire interest received by most lenders. The principal and interest com bined have no greater purchasing power at the end of the period than the principal alone had at the beginning of it. It is the same as if the dollars had been buried during a period of stationary prices.' The modern explanation of this phenomenon was worked out in the period of falling prices before 1896, and hence was referred to as the theory of "appreciation and interest" (meaning the relation of the ap preciating dollar to a falling rate of interest). More generally the theory is that of the relation of a changing standard of deferred pay ments and the rate of interest. REFERENCES.
Bureau of Applied Economics, Changes in the cost of living 1914 1919. P. 55. Washington. 1919.
Fisher, Irving, Appreciation and interest. A. E. Assn., Pubs. 11: 331-442. 1896.
Same, Stabilizing the dollar. P. 206. New York. Macmillan. 1920.
Jevons, W. S., Money and the mechanism of exchange. N. Y. Ap pleton, 1875. Ch. XXV.
Johnson, J. F., Money and currency. Bost. Ginn. 1905. Chs. XI, XII, XVII.
Marshall, L. P. and others. Materials for the study of elementary economics, Chicago University Press, 1913. 787, 788 (extract from Brown, H. G.,), 788, 789 (extract from Clark, W. E., in "How to invest when prices are rising." 1912).
Noyes, A. D., Forty years of 'American finance. N. Y. Putnam. 1909. Chs. I-III.
Phillips, C. A., Ed., Readings in Money and banking. N. Y. Mac millan. 1879. Chs. VI, VII, XIII.