Long time lurker here. I've read the epic PP posts over on the BH forum in their entirety & the PP books, both old & new.
I'm hoping somebody with much better econ chops than I can help with Gibson's Paradox.
From what I understand, Gibson's Paradox describes the counterintuitive finding that interest rates vary with price levels, not with inflation. Barsky & Summers (1985) explain that this is true only under a gold standard. Said another way, price levels vary inversely with real gold prices. If so, real gold prices vary inversely with interest rates.
So is it technically correct to say that nominal gold prices vary inversely with real rates? If so, then it should not have been any surprise to see gold increase when real rates started to go negative in the early 2000's?
Also, since real rates were occasionally negative throughout the bull market following the Great Depression until the late 50's, would gold have done well, or would it have performed similarly to 1982-1999?
Gibson's Paradox
Moderator: Global Moderator
Re: Gibson's Paradox
I read and re-read the Wikipedia entry on Gibson's Paradox 5x. It's poorly written and confusing. I'm not sure what I read. Here's what I can offer with respect to gold and interest rates and inflation:
Step 1) The government (not on a gold standard) prints more fiat currency than they should.
Inflation rises because there's more supply of money. This pushes prices up.
The value of gold increases because gold is essentially "inflation-protection". 1 ounce of gold in 1920 would buy the same amount of stuff that 1 ounce of gold can buy today (adjusting for technological changes).
Step 2) The government decides to borrow money from China.
China says "okay" but we want more interest than you were offering yesterday, before you printed a bunch of new money, because now your money is worth a little bit less than it was yesterday. So you need to raise the interest rate you're paying in order to compensate, such that the net present value of inflation adjusted dollars of the money I lend you today is equal to the net present value of inflation adjusted dollars to the money I lent you yesterday before you printed a bunch more and devalued it.
Thus, interest rates rise because there's more money printed than their should be and due to the devaluing of the money that occurs, people demand a higher interest rate to compensate.
However, when deflation hits, the opposite happens. Interest rates fall and gold goes down. Gold is still worth the same, in inflation adjusted dollars, but the value of the dollar increased due to the deflation.
Of course, this is not a linear relationship. There's speculation built in, because it's a free market, so gold starts to react in advance of inflation/deflation, based on the speculators' thoughts of what will occur. If people think inflation will occur, then the value of gold will go up before the interest rates rise and vise versa for deflation.
What happens if a government with a gold-backed currency? Then gold and dollars move in tandem because there's a fixed relationship between the two. So whatever dollars can do (buy more, buy less, or buy the same), then gold would do equivalently since they are substitutes for each other.
Step 1) The government (not on a gold standard) prints more fiat currency than they should.
Inflation rises because there's more supply of money. This pushes prices up.
The value of gold increases because gold is essentially "inflation-protection". 1 ounce of gold in 1920 would buy the same amount of stuff that 1 ounce of gold can buy today (adjusting for technological changes).
Step 2) The government decides to borrow money from China.
China says "okay" but we want more interest than you were offering yesterday, before you printed a bunch of new money, because now your money is worth a little bit less than it was yesterday. So you need to raise the interest rate you're paying in order to compensate, such that the net present value of inflation adjusted dollars of the money I lend you today is equal to the net present value of inflation adjusted dollars to the money I lent you yesterday before you printed a bunch more and devalued it.
Thus, interest rates rise because there's more money printed than their should be and due to the devaluing of the money that occurs, people demand a higher interest rate to compensate.
However, when deflation hits, the opposite happens. Interest rates fall and gold goes down. Gold is still worth the same, in inflation adjusted dollars, but the value of the dollar increased due to the deflation.
Of course, this is not a linear relationship. There's speculation built in, because it's a free market, so gold starts to react in advance of inflation/deflation, based on the speculators' thoughts of what will occur. If people think inflation will occur, then the value of gold will go up before the interest rates rise and vise versa for deflation.
What happens if a government with a gold-backed currency? Then gold and dollars move in tandem because there's a fixed relationship between the two. So whatever dollars can do (buy more, buy less, or buy the same), then gold would do equivalently since they are substitutes for each other.