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Essay on Knut Wicksell's Contribution to Modern Monetary Policy
Knut Wicksell occupies a significant place in the history of monetary economics as the developer of the "cumulative process" by which deviations between the market and "natural" rates of interest cause the price level to change persistently. A more accurate version of the same argument is a part of classical monetary analysis but there the process originates from a change in base money or central bank credit while Wicksell's version may be initiated by banks capriciously setting their lending rates. Wicksell's version arises from his difficulties in correctly interpreting the classical quantity theory of money and interest rate determination from Hume down to Marshall, but has not been so noted in the literature (Humphrey, 1993).
In his attempted improvement over the classical quantity theory of money in explaining changes in the price level, Wicksell also adopts the classical definition of money to be currency or specie. But he believes that several assumptions underlying the quantity theory bear no relation to reality. The Theory provides a real explanation of this subject matter, and in a manner that is logically incontestable; but only on assumptions that unfortunately have little relation to practice, and in some respects none whatever. These assumptions, according to him, include:
An almost completely individualistic system of holding cash balances. In fact the individual balance has become replaced by a kind of collective holding of balances, out of the acceptances of banks of deposits.
That the velocity of circulation of money is, as it were, a fixed, inflexible magnitude, fluctuating about a constant average level; whereas in practice it expands and contracts quite automatically and at the same time is capable of almost any desired increase, while in theory its elasticity is unlimited......
