A Non-Paradoxical Interpretation of the Gibson Paradox

Abstract

In this study, we show how, to yield the real cost of borrowing, the price level can be combined with the nominal interest rate in a monetary regime where the level of prices is trend stationary. We show that the price level then conveys intertemporal information in a way similar to nominal interest rates. We estimate real interest rate series for the gold-standard period in the United Kingdom under the assumption the agents expect the price level to come back to its long-run equilibrium value. The positive correlation between the price level and the nominal interest rate-known as the Gibson paradox and far from being paradoxical-helps explain why the nominal interest rate was so stable in a period characterized by numerous wars and important gold discoveries. The new real interest rate series provides the opportunity to re-examine Barro's (1987) finding on the effect of temporary military spending on interest rates. It also relaxes the assumption that the nominal long-term interest rate is also the expected real rate.

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