Gibson's Paradox and the Natural Rate of Interest

Luca Benati and Pierpaolo Benigno

No 17959, CEPR Discussion Papers from Centre for Economic Policy Research

Abstract: Gibson’s paradox–the strong positive correlation between the price level and long-term nominal interest rates observed under the Gold Standard–is not inherently linked to the Gold Standard per se. Rather, it originates from low-frequency movements in the natural rate of interest (commonly referred to as R*) under monetary regimes in which inflation is strongly mean-reverting and has an approximately zero mean. While the Gold Standard is the only historical instance of such a regime, Gibson’s paradox can in principle emerge under a broader class of monetary arrangements. Indeed, once the deterministic component of the price level’s drift is removed, the same co-movement patterns can be recovered from data generated under contemporary inflation-targeting regimes. In line with the inefficiencies highlighted by the literature on metallic standards, this finding suggests that modern regimes are not immune to criticism, as fluctuations in R* account for significant portions of the variation of inflation and output.

JEL-codes: E2 E3 (search for similar items in EconPapers)
Date: 2023-03
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Working Paper: Gibson s Paradox and the Natural Rate of Interest (2023)
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