What is the Gibson Paradox, and why is it called a paradox?

The Gibson Paradox is named after British economist Alfred Herbert Gibson, who observed the positive correlation between interest rates and the general price level in the early 20th century. The paradox arises from the fact that classical economic theories predict an inverse relationship between interest rates and price levels. In other words, when interest rates are high, it should be more expensive to borrow money, leading to a decrease in aggregate demand and a subsequent decrease in the general price level.

The positive correlation observed in the Gibson Paradox can be explained by looking at the relationship between the nominal interest rate, real interest rate, and inflation. The nominal interest rate is the observed interest rate in the economy, while the real interest rate is the nominal interest rate adjusted for inflation. The following equation represents this relationship: \[Real\,Interest\,Rate = Nominal\,Interest\,Rate - Inflation\] When the real interest rate is constant, an increase in inflation leads to an increase in the nominal interest rate, which is what Gibson observed.

Classical economic theories assume that interest rates will react to changes in the general price level, meaning that high interest rates should lead to a decrease in aggregate demand and a subsequent decrease in the general price level. This assumption contradicts the positive correlation observed in the Gibson Paradox. Several explanations have been proposed to reconcile this contradiction: 1. The Fisher effect: This theory, proposed by Irving Fisher, suggests that the observed positive correlation between interest rates and price levels is due to changes in inflation expectations. When market participants expect higher inflation, they demand higher nominal interest rates to compensate for the expected decrease in the purchasing power of their money. This leads to a positive correlation between interest rates and price levels. 2. The monetary policy reaction: Central banks may increase interest rates in response to rising inflation in an attempt to maintain price stability. This reaction can create a positive correlation between interest rates and price levels, as observed in the Gibson Paradox. 3. The liquidity preference: When inflation is high, people may prefer to hold more liquid assets to protect themselves from the eroding effects of inflation on their purchasing power. This increased demand for liquid assets can drive up interest rates and create a positive correlation between interest rates and price levels. In conclusion, the Gibson Paradox refers to the observed positive correlation between interest rates and the general price level, which contradicts the inverse relationship predicted by classical economic theories. Various explanations have been proposed to account for this paradox, including the Fisher effect, monetary policy reactions, and liquidity preferences.