Gibson's Paradox - Explained
What is Gibson's Paradox?
Written by J. Mance Gordon
Updated at April 23rd, 2024
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What is Gibson's Paradox?
Gibson's Paradox is an economic observation that posits that a positive correlation exists between the general price levels and nominal interest rates. This correlation has been observed over a long period of time. The Gibsons Paradox is attributed to a British economist, Alfred Herbert Gibson who observed the correlation between interest rates and wholesale price levels in his article written in 1923. However, the correlation between the nominal interest rate and the price level was first observed in 1844 by Thomas Tooke.
How is Gibson's Paradox Used?
Although Alfred Herbert Gibson was the first to observe the paradox, it was named by J.M. Keynes in his research titled; "A Treatise on Money." Keynes was one of the first economists to accept Gibsons paradox while other economists opposed it. As at the time the paradox was observed and popularized, it was in conflict with the opinion held by economists at that period. Economists at the period believed that there is a correlation between interest rates and rate of inflation while Gibsons paradox observes that there is a correlation between interest rates and price levels. Gibsons paradox resulted from years of observation backed with empirical evidence that shows that interest rates are correlated with the wholesale price level, thereby dispelling the widely held notion by other economists. Gibsons paradox resulted from years of observation backed with empirical evidence that shows that interest rates are correlated with the wholesale price level, thereby dispelling the widely held notion by other economists.
The Relevance of Gibson's Paradox Today
Gibsons observation of the correlation between interest rates and price levels was tagged a paradox because there was a precise explanation for the correlation. In modern economics, the relevance of Gibsons paradox has been greatly challenged given that the basis for the correlation earlier observed by Gibson no longer exists. The gold standard was also one of the reasons the relevance of Gibsons paradox was challenged. Also, the relationship or correlation between price levels and interest rates have been delinked, thereby making the paradox irrelevant. In modern economics, the central banks now manage inflation using interest rates based on the belief that they are not correlated. The use of monetary policies by Central banks has suppressed the relevance of Gibson's paradox.
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