Sec. 8. #Fluctuating standard and the interest-rate.# In connection with the standard of deferred payments there is presented a problem of the effect that fluctuations of the standard may have upon the interest-rate.[11] As the general price-level falls or rises, the monetary standard conversely appreciates or depreciates.[12] If these changes are slight in amount and imperceptible in their direction they may not affect considerably the motives of borrowers and lenders.  Therefore, the rate of interest this year in long-time loans would be just that resulting in the expectation, on all hands, of a stationary level of general prices.  Suppose that rate to be 5 per cent on the standard investment (such as real-estate loans and good bonds).  Then the lender of $1000 will receive each year a $50 income and at the end of the investment period $1000 principal, each dollar of which will purchase the same composite quantum of goods that a dollar would have purchased at the time the loan was made.  Likewise, the borrower would pay interest and principal in a standard that reflected an unchanging general level of prices.  But, now, if the general level of prices unexpectedly falls 1 per cent within the year, the creditor of a loan maturing at the end of the year would receive (principal and interest) $1050 which will purchase 1 per cent more goods per dollar than the sum he loaned, or (approximately) $1060 worth of goods.  Hence, he has received, in quantum of goods, a yield of 6 per cent on his investment.  If this change continues for five years, the lender of a five-year loan would receive each year $50 having a purchasing power successively 1, 2, 3, 4, and 5 per cent greater than the same sum had at the making of the loan; and at the end of the five years would collect the principal, having a purchasing power 5 per cent greater.  The lender, on his part, would have to pay interest and repay the principal in a money that is to be obtained only in exchange for a larger sum of goods than that which could be bought with each dollar that he borrowed.  This means that, with individual exceptions, creditors generally gain and debtors lose by falling prices.

But this is fully true only in respect to loans already made.  For just to the extent that such a movement of prices comes to be more or less regularly in the same direction, both borrowers and lenders are able to take it into account, and as experience shows, do take it into account.[13] When prices fall men become more eager to sell wealth, to lend the proceeds, and more reluctant to borrow for investment at the prevailing rate of interest and at the prevailing prices.  There is an incentive to divest one’s self of ownership (e.g., by selling stocks) and to become a lender (e.g., by buying bonds).  This whole situation is reversed in a period of rising prices.  The result is that the rate of interest in any long continued period of falling prices (such as from 1873 to 1896) has a trend downward and in a period of rising prices