Ohio State University Press Journal of Money, Credit and Banking

The Psychological Rate of Interest
Author(s): Maurice Allais

Source: Journal of Money, Credit and Banking, Vol. 6, No. 3 (Aug., 1974), pp. 285-331
Published by: Ohio State University Press
Stable URL: https://www.jstor.org/stable/1991172
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MAURICE ALLAIS
The ideas and the theories of our predecessors should not

be preserved except insofar as they represent the state of
science. But these ideas are evidently subject to change,
unless we assume that science should no longer advance,
which is unthinkable.
Claude Bernard, Introduction to the

Study of Experimental Medicine (1865)1
The Psychological Rate of Interest
I. INrRODUCTION
In an earlier article, "Forgetfulness and Interest,"2 I showed how the

hereditary and relativistic formulation of the theory of the demand for
money can be applied to provide a precise and operational expression
of the psychological rate of interest. This leads in turn to a deepening
of understanding, in new directions, of the general theory of interest. This
is the main purpose of the present article.3 4
As far as can be judged, the analysis presented below, which later may
be refined and revised, seems capable of clarifying certain aspects of a
complex and controversial question which has been under discussion ever
since the beginning of the eighteenth century, namely, the link between
2AIIaaUisde[ s7eJrnard [25], pp. 74 75
3 This puper follows up the earlier stlldy on "Forgetfulness und Interest" fl7], which the
reader is invited to consult.
4The present article's text mainly consists of substantial extracts from a mimeographed
document dated April, 1970, under the title "Forgetfulness and Interest" [16].
MAURICE FELIX CHARLES ALLAIS is professor of economic analysis at the Ecole

Nationale Supe'rieure des Mines de Parts and Faculte' de Droit et des Sciences
Economiques de l'Universite de Paris-X. He is also Research DirectorS National
Center of Scientific Research.
286 : MONEY, CREDIT, AND BANKING
TA-BLE 1
THE NEW THEORY
Main Definitions and Notation
M = Money balances actually held (the money supply)

MD = Desired money balances
D(t) = Global expenditure
1 dD(t)
x(t) = = Instantaneous rate of (1.1)
D(t) d(t) increase of global expenditure
i (t) = Psychological rate of interest at instant t
X (t) = Rate of forgetfulness at instant t
Z(t) = Coefficient of psychological expansion (1.2)
I ( ) e-ftx(")dud
_r
Main Relationships
i X 1
= = XO=X(Z=O); iO= E(Z=O); XO= iO (1.3)
io Xo +(Z)
1 + b
1 + beaZ (1.4)
a = 1; b= 1; XO = 0.004permonth (1.5)
-= X _ X° Z (1.6)
dt 4(Z)
MD
MD= OOD+(Z); ¢0= D (Z= °) (1.7)
the money supply, prices, production, and

which in many respects runs counter r
views (whether of the monetarist Chicag
has the particular advantage that it int
link between the money supply, the pr
of interest in the framework of a single m
The definitions and notations used, to
of the new theory, are summarized in Table 1. 5
II. THE DIFFERENT RATES OF INTEREST
Economic analysis should distinguish at least three rates of interest;

these are the psychological rate of interest, i, used by the collectivity to
5See Allais [17], Sec. 2, Tables 1 and 2, and Sec. 25, Table 4.
MAURICE ALLAIS : 287
discount the future,6 the pure short-term rate of

called the pure monetary rate of interest, iM, and t
of interest, which may be called the pure financial
For a given short-term investment yielding an ob
which is specified in nominal value and does no
have
ic = ic + IcS (2. 1)
using ic to designate the corres

liquidity premium.7
For a given long-term investment yielding an observed return of il, we
have
il = il + ll + Fl- pl, (2.2)
where il, ll, ,ul, and Pl respectively de

of interest, the liquidity premium, the prem
tion, and the corresponding risk premium
The pure monetary rate of interest iM
of the pure short-term interest rates ic
of interest iF can be considered as the
interest rates il. Ithe pure rate of inte
invested free of risk and so as not to y
any prospect of nominal capital apprecia
T1te regrettable confusion of much cur
traced to the failure to distinguis1? clear
between certain of them.
In the first instance, a careful distin
6 See Allais [1], Sec. 40, pp. 99- 100 and 778. The r
broadly to Bohm-Bawerk's rate of interest (see
Fisher's concept of "Time Preference" (see Fis
to Ludwig von Mises's concept of "originary
note 28 below).
Wicksell's natural rate of interest (Wicksell [121], English edition, 1936, chap. 8; and
[122], English edition, 1946, pp. 168-208) is certainly different from the psychological rate
of interest defined here, but in my opinion his reasoning would become far more convincing
if the concept of the natural rate of interest were replaced by the concept of the psychologica
rate of interest.
7A liquidity premium lc should be added to the rate of interest jc to allow for the extra
advantage that the short-term claim held can readily be converted into cash.
8Unfortunately, in numerical applications, the liquidity premium is ordinarily not taken
into account.
Thus, for example, the estimate of the elasticity of the demand for money with respect
to the rate of interest given by Laidler ([93], p. 549) could easily be -1 if the liquidity
premium corresponding to a given rate of interest had been included in the analysis, as
it should have been. (See also the notes 45 and 84 below).
9Adetailed analysis can be found in Allais [1], chap. 8, Sec. 84, pp. 253-63. For simplicity,
the other components of the rate of interest, such as administrative expenses, are ignored
here.
pure interest rates corresponding to given investments

market rates which are all that offer themselves to dir
Secondly, in any given historical situation, the pure int
sponding to alternative forms of lending are not in gen
psychological rate of interest. This could only happen in
*t-s -
equlllorlum.
What does exist at any given moment is a certain tendency for the
various pure rates of interest to equalize. Thus, as far as can be judged,
the pure rate of interest corresponding to British Consols in the nineteenth
century only adjusted to the psychological rate of interest with some delay,
the lag being of the order of 18 months.10
The interest rate i considered in the new theory is the psychological
rate of interest. It is this rate which expresses the fundumental trude-off
made by economic agents as between the present and the future. It is definitely
not identical to any of the market short-term or long-term rates of interest.
In a state of dynamic equilibrium, the psychological rate of interest
considered here corresponds to what might be called the rate of interest
on a risk-free bond with no liquidity advantage.1l
The yield on British Consols j in the nineteenth century is a reasonable
approximation of the return on a long term risk-free loan offering no prospect
of nominal capital gain or loss, so that, from relation (2.2), the corresponding
pure rate of interest can be written, at least as a first approximation,
ij=j+lj (2.3)
in which lj stands fo
It may also reasona
tends to equalize th
of interest i, so that
ij = i + e (2.4)
in which e can be conside

as a random parameter of
Combining (2.3) and (2.4), we deduce
i = j + lj - c. (2.5)
I°See Allais, [17], Sec. 36, and note 60. For a better estimate of j's lag against j*,
that is of j behind i, the analysis would have to be carried out using estimated monthly
data of j, P and Q, which, at least as matters stand presently, are not available for the
nineteenth centllry. However, the results of the statistical analysis indicate a lag of approxi-
mately 18 months (see Allais [18]).
Allais [1], pp. 262-63.
See Sec. 4 below.
Insofar as it is justifiable to suppose that
Ij= Aj, (2.6)
where A is a constant, there follows
i= (1 + A) j-6- (2.7)
Relation (2.7) was used to confront the theory with observed data under
the assumption that e remains small enough to be neglected, at least as
a first approximation.13
The analysis of the results obtained for the nineteenth century does
not show that long-term rates of interest would be wholly determined by
the coefficient of psychological expansion Z. All it can show is firstly
that, on average, there exists a tendency to the equalization of the pure
rate of interest ij corresponding to the observed rate of return j, with the
psychological interest rate i as determined by application of the new theory,
the ratio of the two rates ij and j being assumed to remain broadly constant,
and secondly, that in this process of equalization, the psychological interest
rate leads the long-term interest rate by about 18 months.14
In point of fact, changes in the coefficient of psychological expansion
Z only partly explain changes in j.15 In particular, it is perfectly clear
that the long-term rate of interest is influenced by monetary policy via
the operation of short-term interest rates.l6
Yet the results obtained show that in the nineteenth century the long-term
trend of the long-term interest rate was almost entirely governed by that
of the psychological rate of interest.17 Only short-term cyclical fluctuations
are more marked for the psychological interest rate.18
Although in the nineteenth century the yield on British Consols j is
lagged by some 18 months against the estimated value i* of the psychological
3Allais [17], Sec. 33, relation (33.2).

14Allais [17], Sec. 35-36. There naturally remains to analyze the nature of the lag of
the order of 18 months of the long-term rate of interest vis-a-vis the psychological rate
of interest. This will be examined in a forthcoming publication.
15The size of the coefficient 1 - r2 = 1 - 0.8312 = 0.309 for the correlation (j, j**)
(Allais [17], Sec. 36) demonstrates the substantial influence of factors other than Z.
Unfortunately, a few errors crept into the paper referred to. Read: in Sec. 35 and chart
II: e = 0.0847 instead of e = 0.0884; r= 0.786 instead of r= 0.771; and 1 - r2 = 0.381
instead of 1 - r2 = 0.404; in Sec. 36 and Chart IV, e = 0.0671 instead of e = 0.0663.
16In point of fact, there are complex links of interdependence between the psychological
rate of interest, the short-term rate, the long-term rate and the money supply. They cannot,
however, be taken up in the limited space of the present article.
See Allais [17], Charts II and IV (Secs. 35 and 36).
18See especially Chart IV of the preceding study (Allais [17], Sec. 36). This circumstance
seems reasonable enough if we consider that the long-term rate of interest may be viewed
as implementing a certain hereditary average of short-term rates, and that in any event,
the fluctuations of the product PQ certainly overstate those of global expenditure.
rate of interest,l920 it is a noteworthy finding that the market short-term

rate of interest k is lagged2l by some 6 months only against the estimated
value i* of the psychological rate of interest, and that, all in all, their
cyclical fluctuations turn out to match quite closely, as can be seen in
Chart I, which shows the short-term rate of interest as lagged 6 months
behind the psychological rate of interest i.22 23
It should also be stressed that the difference between the psychological
rate of interest and the pure rates corresponding to the market long- and
short-term interest rates plays a major role in the development of the
economy, at least as important as that played by the difference M-
MD between the money supply and desired money balances.24 However,
the dynamic relations in which the differences between the three pure
interest rates operate have yet to be specified.25
III. THE EPRESSION FOR THE PSYCHOLOGICAL RATE OF INTEREST
If the new theory is correct and given the information presently available,
the data are what one would expect if it were the expression for the
psychological rate of interest is
i 1 1 +eZ
lo t(Z) 2 ' (3.1)
9Allais [17], Sec. 35 and Chart II. We have:
4.8
i*= %,
+*(T
where Zcorresponds to the calculated value in Sec. 34 of [17].

20The estimate j* of j has been assumed to be proportional to the psychological rate
of interest i (Allais [17], Sec. 33, relation 33.2)
21The data used for short-term rates were, for the period 1824 to 1844, Gurney's "Rates
for First-Class Three Months' Bills," and for the period 1845 to 1913, the "Rates for Three
Months' Bank Bills" (B. R. Mitchell and Phyllis Deane [104], p. 460).
22There corresponds to Chart I the approximate relationship
k= 2i- 8.6%.
The coefficient of correlation between k(t) and i*(t) is 0.668 (1 - r2 = 0.554) to be

compared with r = 0.832 (1 - r2 = 0.306) for the correlation between j and j** (Allais
[17], Sec. 36). Thus the association between k and i* is considerably less marked than
that between j and j**.
23Comparative movements in short-term interest rates (rate for three months bank bills)
and long-term rates (the yield on Consols) during the nineteenth century will be reviewed
in a forthcoming study.
It is quite striking that the average values over the span 1824 to 1913, for which data
are available for short-term rates, are practically equal: 3.35 percent for the short-term interest
rate and 3.13 percent for the long-term rate.
240n this point, see Allais [3] and [17], note 34.
25 From a purely qualitative point of view, most of Wicksell's reasoning could be considered
as an important input to this study if in place of the natural rate of interest, the concept
used were that of the psychological rate of interest. See for example Wicksell [122], chapter
4, Secs. 7; 8, and 9, and especially page 201; see also note 6 above.
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with
io = 4.8% per annum (3.2)
and
dZ
-+0.024(1+eZ)Z=x (3.3)
dt
using the year as time unit, and where x stands for the annual rate of
increase of global expenditure.26
It follows that the position is what one would expect it to be if the
psychological rate of interest were wholly determined by past changes in
global expenditure.
If this is so, and if, as seems natural, the level of the psychological
rate of interest is to be considered as governing that of other interest
rates, it follows that the theory that the interest rate is given as the rate
which equalizes savings and investment27 should be revised, while Bohm-
Bawerk's and Ludwig von Mises's view that preference for the present
should be considered as a psychological datum28 would be considerably
reinforced.
The most forthright expression of this view has no doubt been presented
by Ludwig von Mises, who writes:
Originary interest is not "the price paid for the services of capital." The
higher productivity of more time-consuming round-about methods of produc-
tion which is referred to by Bohm-Bawerk and by some later economists
in the explanation of interest, does not explain the phenomenon. It is, on
the contrary, the phenomenon of originary interest that explains why less
time-consuming methods of production are resorted to in spite of the fact
that more time-consuming methods would render a higher output per unit
of input.... People do not save and accumulate capital because there
is interest. Interest is neither the impetus to saving nor the reward or the
compensation granted for abstaining from immediate consumption. It is the
ratio in the mutual valuation of present goods as against future goods. The
loan market does not determine the rate of interest. It adjusts the rate of
interest on loans to the rate of originary interest as manifested in the discount
of future goods.29
The estimate i* for the psychological rate of interest is given from (1.3)
as 3o
i* = t* (Z) , (3.4)
26See Table 1, relations 1.1 and 1.3 to 1.6. If the year is taken as time unit, we have
io = 12 X0 = 12. 0.004 = 4.85S,
io being the annual rate of interest and Xo the monthly rate of forgetfulness.
27See Allais [1], Sec. 48, pp. 143-44; Sec. 97, pp. 301-18; Sec. 99, pp. 335-58; and
Secs. 134-36, pp. 477-98. See also Irving Fisher [61], parts II and III.
28On this theory, see Bohm-Bawerk [27], especially the end of chap. 15; von Mises
[103], chaps. 17-20, especially chap. 19, pp. 520-34; and Allais [1], Sec. 130, pp. 458-85.
See also Allais [4], Sec. 32, pp. 19-20, and [13], Appendix C, Sec. 7, pp. 421-22.
29Von Mises [103], pp. 523-24. In his day, Sylvio Gesell took a very similar stance in
[69]. (On this point, see Keynes's thought-provoking summary in chap. 23, Sec. 6 of [90],
French translation, p. 369; see also Allais [13], p. 449, Sec. 11.)
30Since we have (Allais [17], Secs. 33 and 35, relations 33.9 and 35.1)
i* = Fo i* Fo = 1.9 (1)
there follows
(2)
in* = 1.9 i n
with
io = 4.8%, (3.5)
the unit of time being the year.

It will be seen that to the extent that the new theory is correct, it
provides a means of estimating the psychological rate of interest, which
hitherto has been a more or less metaphysical, and in any case nonoperation-
al, concept.31
The hereditary, relativistic, and logistic formulation of the demand for
money was first applied to the link between money and prices in 1962,
but it was only in 1968 that I extended it to the question of the rate
of interest.32 If the ideas underlying the theory are valid, they should
imply expression (3.1) for the rate of psychological interest. Applying the
new theory to the rate of interest during the nineteenth century subjected
it to a redoubtable test, since the formulation it implies, in particular the
values of the constants (x, b, and XO' was deduced from empirical data
pertaining to money and prices for current situations and the hyperinflations
in the twentieth century only. In these circumstances, the fact that the
test was successful makes it all the more significant.
Of course a substantial number of applications of the theory remain
to be undertaken, but there is reason to believe that possibly they will
be equally satisfactory. For example, Keynes notes in his Tract on Monetary
Reform that, at the end of the German hyperinflation in the first half
of 1923, the rate of interest reached levels of 150 percent rising to 1200
percent per annum over the period July-September 1923.33 According to
my computations,34 we have
t* 0.045 for the first half of 1923;
t* 0.0065 for August-September 1923.
And from equation (3.1) the corresponding psychological rates of interest

are derived as
i=4.8/0.045= 110%perannum;
i = 4.8/0.0065 = 740% per annum.
31On this analysis, see Allais [14], Secs. All, pp. 448-49, and B3, pp. 451-52.
32In lectures given at the turn of the year 1967/68 (see Allais [17], note 7).
33Keynes [88], chap. 1, Sec. 2, French translation, p. 41. It is curious to note that of
all the authors who have given more than superficial attention to the German hyperinflation
(e.g., Bresciani-Turroni [28]; F. D. Graham [72]; J. P. Young [127]), Keynes is the only
one who saw fit to devote a few lines to the movement of interest rates in hyperinflations,
whereas study of this movement is obviously of capital importance for economic theory.
34Allais [81, p. 183-
Both estimates are of the same order of magnitude as Keynes's appraisal

of the observed market rates for loans.35
It may also be noted that the psychological rate of interest defined by
the new theory provides a full explanation of the apparently paradoxical
relationship between the level of interest rates and the price level the
"Gibson Paradox." Space is too limited to include this analysis in the
present study, and it will be published separately in due course.36
IV. THE LIQUIDITY PREMIUM ON BRITISH CONSOLS
In the present state of our knowledge, it is no easy task to specify

exactly the factors on which the liquidity premium on British Consols
lj depended during the nineteenth century, and correspondingly, all the
more difficult to specify the exact expression for the premium as a function
of these factors.
Nevertheless, it is probably not unreasonable, as a first approximation,
to view the premium Ij as involving both a constant element and a cyclically
variable element, so that it appears possible to write
Ij=lo+>[i-io]+5l (4.1)
in which lo and ,u are two constants and n may be considered as a stochastic

parameter with zero mean. 37 Applying (2.5), it follows that
i-j=lo+>(i- io)+ N-6 (4.2)
whence
i= i + o Fo +N . (4.3)
1-> 1-> 1- F
If we assume that
i* = i + ', (4.4)
where i* is the estimate made for iS38 and that {' is a stochastic variable
with zero mean, we find
35As already noted, the monetary rate of interest generally differs from the psychological
rate of interest (Sec. 2 above).
36Allais [18]
37This is of course only an assumption, but evidently it is more general than the hypothesis
of simple proportionality considered in my preceding paper [17], which corresponds to the
condition lo = F io (see notes 43 and 44 below).
38Corresponding to relation 3.1 (Allais [17], Sec. 35).
n _ e
i 1 - UxF 6 (4.5)
after writing
* .
i = I + 1O->lO (4.6)
1-> 1->
The parameter ij here can be considered as the pare rate of interest

corresponding to the rate j under the assumption made.39
The observed correlation between i* and j yields the relation:40
i* = 1.67 j + 0.0081 (4.7)
to which the corresponding values of A, jO, ,u respectively are, from (4.5)

and (4.6)
( lo = 2.41% > = 0.40 (4.8)
t jO= 2.39%
where jO is the value of j for z = o.41

From (2.3), (2.4), and (4.4):
Ij= i* - j + e- {', (4.9)
and, using (4.7):
Ij = 0.67 j + 0.0081 + o (4.10)
in which o can be considered as a random variable.

According to (4.1) lo represents the value taken by Ij for Z = 0, i.e.,
it is the liquidity premium on British Consols in a process in which global
expenditure remains constant.42
39It seems perfectly feasible to assume linearity, at least as a first approximation.

40With a coefficient of correlation of
r= 0.772 and 1 - r2 = 0.404.
4lIn fact, we have
i 4 8% 1 1 67 lo - Fio 0 0081 j i l
l-,uw l-,uw
42Curiously enough, we have almost exactly jO = io/2. More thorough analysis is required
to determine whether this means anything or is just a coincidence.
An approximate estimate for jO can be derived from relations (33.8) and (35.1) of my
Using (3.2) and (4.8), equation (4.7) can be written altern

** -
= 0.83 1 + 0.17 (4.11)

lo lo
It can be seen that,

my preceding study43
In any case it goes wi
It is a pity that up
contemporary researc
premium attaching t
contemporary literat
preceding article (Allais [17]), from which
io 4.8
io= =-%= 2.52%.
Fo 1.9
aSsnlce, f4o8mO(2.12,520O- io2+288¢, the approximate value of t
These values of jO and lo differ slightly from those given

lo = 2.41 percent). The computation in this note assumes t
Sec. 33 of the preceding article of Allais [17]), an assumpt
verified and not embodied in the calculations in Sec. 4, w
dependence (4.1).
The value of Fo corresponding to jO as given in the text (2.39 percent) is
io 4.8
Fo=-= = 2.01
iO 2.39
in Vlace of the value F = 1.9 given in Sec. 35 of Allais [17].

3Allais [17], Sec. 3%. This result corresponds to the fact that in rel
lo - ,uw io = 0.0241 - 0,4.0,048 = 0.0049 is relatively small.
44If the computations in the earlier article were repeated, as a
using an expression for i* of the form i* = A. + B, better resu
obtained, by reason of the extra degree of liber'ty involved in con
B. The fittings obtained (Allais [17]) would be of better quality.
4s However, recent empirical studies of the relative liquidity premium
are of considerable interest: see for instance Kessel [87], Conard [
There are in addition two excellent studies of the structure of i
payments by, banks in eleven countries, published by the "Uni
[119 and 120]. Although neither addresses itself to the study of t
seems that they provide the raw material for an estimate of it t
level (x of the interest rates at which the public is prepared to b
should, broadly speaking, correspond to the psychological rate of
of the interest rates received by economic agents on their loans o
interest) should broadly correspond to the difference (i - l) so tha
l, a value translating the psychological advantages attaching to the ava
should be of the same order of magnitude as (x - 7r.
V . THE DEMAND FOR MONEY AND THE RATE O
In the new theory, the demand for money is defined by the relation46
MD = 4)0 D t (Z) (5. 1)
the rate Z being itself hereditarily dependent on past changes in global

expenditure.47
5.1 Empirical analysis shows that this is a stuble funotionS invariant
over space and in time, of past rates of change of global expenditure.
This invariance is verified in very different circumstances, as for example,
in the Great American Depression of 1929-34, or in the German hyperinfla-
tion of 1919-23, as well in very different institutional environments, such
as the western capitalist economies or the collectivist economy of Soviet
Russia.
Not only is the same formulation applicable to different countries at
different times, but with fewer degrees of liberty, it gives far better results
than any of the formulations put forward hitherto, whether based on Phillip
Cagan's coefficient of expectation or Milton Friedman's permanent in-
come. 48
The importance of the criterion of structural stability or of invariance
cannot be overestimated. Too hasty conclusions are derived by too many
contemporary studies, which consider only one country, namely, the United
States, and only the postwar era, or even a subperiod of this era.
By the same tokenS the number of arbitrary parameters in a model is
an essential criterion. We have to keep in mind the very strong autocorrelation
of the series, and their correlation with time in numerous cases. This
is the reason why we cannot fail to obtain some superb correlations if
there are more than a few degrees of liberty. Nevertheless, it is clear
that they are practically devoid of real significance.
46Relation 1.7, Table 1. Modigliani, Rasche, and Cooper [ 106] write: "Allais' basic
proposition is that the velocity of circulation is an exponentially weighted average of past
changes in money income" (p. 169). This is an inaccurate interpretation, since it is not
the velocity V of circulation of money that the new theory considers but the relative desired
cash balances M /D, which is a very different concept.
In any case, tie relation (1.2) shows that the weighting considered is more complex in
form than a straightforward exponential.
47Etelation 1.2, Table 1.
48On the stability of the hereditary and relativistic formulation, see Allais [8] Sec. 3
pp. 20-21, Sec n, p. 141, and Secs. 54-55, pp. 155-57; and [9], pp. 1149 and il56; see
also [ 15], pp. 453-54.
On Cagan's and Friedman's theories, see Cagan [35], Friedman [63], chap. 6, and Laidler
[92 and 93]. See in particular Allais [8], pp. 153 and 167-80, and [9], pp. 1154-55.
298 : MONEY, CREDIT AND BANKING
5.2 As regards dynamic economic causality and according to relation

(5.1), the demand for money depends only on the level of global expenditure
and its past changes, and should be considered as cuusully independent
of the monetary rate of interest.49
In parallel with this, we have the relation5°
i 1
i0 'P(Z) (5.2)
as the expression for the psychological rate of interest. The two relations
(S.1) and (5.2) then yield
D = +° , (5.3)
In other words, desired

und inversely proportional to the psychological rate of interest.
As each of the three relations (S.1), (5.2), and (5.3) results identically
from the two others, there is no reason not to consider that only relations
(5.2) and (5.3) are economically meaningful. Nor is there any gainsaying
from the economic standpoint the indisputable appeal of (5.3).5'
5.3 The fact remains that with the market monetary rate of interest
in general differing from the psychological rate of interest,52 relation (5.3)
cannot be interpreted as defining the demand for money as a function
of the market monetary rate of interest.
Further, even if the global money supply M is found to be correlated
with the monetary rate of interest observed on the market,53 this cannot
be used to argue a causal relation between the market monetary rate of
interest and desired money balances.
It follows from the foregoing that for a given value of global expenditure
D, desired money balances MD are inversely proportional to the psycho-
logical rate of interest. Since there is necessarily some interdependence
between the monetary and psychological rates of interest, analysis of
49Which should not be taken to mean that no correlation is to be observed between the
money supply and the monetary rate of interest (see Sec. 7 below, note 86).
50Relation 1.3 of Table 1.
510n fairly plausible assumptions, this relation can be established directly on the basis
of considerations pertaining to the budgetary equilibrium of consumers. (See Allais [13],
Secs. Cb and Cc, pp. 412-13, in particular relation C-13. In this study, the first line of
page 412 should refer to B11 and B12 instead of B3-1 and B3-2).
52See Sec. 2 above.
53There is an immense literature on the relationship between the money supply and the
rate of interest. Among the most significant empirical studies are those of Burgess [33],
Gurley [74], Cagan [38], Chow [471, Friedman [62], Hambalrger [77], Laidler [92] and
[93], Cagan [49], Cagan and Gandolfi [43], Galper [68], Hamburger [78], Lee [98 and
99l. Hamburger and Silber [79], and Frost and Sargent [67].
empirical data might lead to the finding that for a given level of global
expenditure, the money supply moves in the opposite direction to the
monetary rate of interest. However, it is well known that a simple correlation
cannot be used to conclude that a direct causal relationship exists.S4
In reality, the psychological rate of interest and the pure monetary rate
of interest are two different quantities; and although the spontaneous
operation of the economic mechanism generally tends to bring the pure
monetary rate5S closer to the psychological rate, they can be dissociated
by economic policy, with the further inevitable consequence of engendering
harmful disequilibria. Again, if at a given time the psychological rate of
interest is effectively determined solely by past changes in global expendi-
ture, it clearly cannot be affected by manipulation of the short term rates
of interest undertaken for purposes of monetary management policy.
5.4 Admittedly, the money supply depends on the monetary rate of
interest, or more exactly, these two quantities are correlated; but it does
not follow that relative desired money balances MD /Dare to be considered
as directly dependent on the market monetary rate of interest. The available
empirical data suggest a process which is as if relative desired money
balances MD/D depended only on past changes in global expenditure.
And, at all events, relative desired money balances is a psychological concept
which escapes any attempt at direct measurement, and can only be estimated
in the framework of a specific model.
At most, as has just been noted, the market monetary rate of interest
may act indirectly on global desired money balances MD' via its effect
on global expenditure D, through the money supply M, but not via any
direct action on the ratio MD /D, which appears to be causally independent
of it.
5.5 Naturally, in a dynamic equilibrium, where
M= MD iM = i (5a4)
that is, where the money supply and the desired money balances are equal
and where the pure monetary interest rate is equal to the psychological
rate of interest, the relation (5.3) can be written
M = +0 io . S (S .5)
IM
-54It is not without interest to recall here Phillip Cagan's conclusion to his 1969 study
[41]: "Properly interpreted the data give no indication of an important interest sensitivity
in the money supply" (p. 262).
On this point, see also Rasche [112] who writes: "A broad, but valuable conclusion
is that the interest elasticity of the money supply . . . appears to be extremely low" (p.
19). See also Friedman's point of view which excludes (but without empirical proof) the
rate of interest as an explanatory variable of the demand for money (See Friedman [63],
p. 122, relation 1, and [66], part 4, Milton Friedman's Reply).
55See Sec. 2 above.
300 : MONEY, CREDIT AND BANKING
but in the case considered, this relationship is one specifying interdependence,

and no more than that5657; and in any event, the pure monetary rate of
IntereSt iM cannot be identified with the monetary rate of interest as observed
on the market.58
Relation (5.5) shows that when states of dynamic equilibrium are
compared, the elasticity of the money supply with respect to the pure
monetary rate of interest should be equal to -1, when comparison is made
for situations in which the level of globul expenditure is the same.S9 Similarly,
the elasticity of the money supply with respect to global expenditure should
be found to be unity providing the pure monetary rate of interest iM is
the same in the situations compared.60
5.6 There can be no doubt that many analyses are erroneously based
on the implicit hypothesis that at least one of the relations (5.4) is verified.
Yet such an assumption is valid only in very particular cases. In general,
the two differences M - MD and i - iM cannot be taken as zero, and,
their role being an essential oneS they must not be left out of account.
At all events, the short-term rate of interest as observed on the market
differs from the pure monetary rate iM, the size of the difference being
given by the liquidity premium.
The adjustment of M to MD occurs through an increase or a decline
in global expenditure,61 and the ratio MD/D of global desired money bal-
ances to global expenditure (which, according to the hereditary and relativis-
tic formulation, is the result solely of past changes in global expenditure)
therefore wholly escapes government control at a given moment.
5.7 Finally, it should be stressed that notwithstanding the generally held
view to the contrary,62 in studying the demand for money, the operative
560n this analysis, see Allais [14], Sec. A6-A10, pp. 444-48, Sec. B14, pp. 458-59, and
Sec. B16, p. 460.
s7In a nonequilibrium dynamic situation, there are reasons for considering that
iMD = iMM,
where i is the psychological rate of interest and iM the pure monetary rate of interest (see
sec. 2 above). If this is so,
M- MD i iM
M i
See Allais [13], note 100, p. 413. This, however is no more than a conjecture at present.
58The difference being given by the liquidity premium (see sec. 2 above).
59See note 8 above. s
60See Allais [8], note 93, p. 86.
6tSee Allais [2] and [3]. The theory presented in these two studies is based essentially
on an equation that I have referred to as "the fundamental equation of monetary dynamics,"
which determines changes in global expenditure as a function of the difference M- M
between the actual and the desired money supply (for a simplified exposition, see Allals
[10], Vol. 1, pp. 75-85). To my knowledge the model corresponding to this theory is the
first in the economic literature which explicitly takes the difference M - MD into account.
62See for example Friedman [63] and Cagan [37 and 40].
variable to consider is global expenditure and not the price level. Not only
are desired money balances proportional to the global expenditure D, i.e.,
to the product PQ of price and production indexes, but the coefficient
of psychological expansion Z is derived from the rate of change of global
expenditure63 and not from the rate of change of prices. Apart from the
fact that the theoretical analysis justifies this point of view, consideration
of global expenditure provides much better empirical fits of the data than
when prices are used.
It may be recalled that, providing the ratio (M- MD)/Mis sufficiently
small (which it is in general), relation (5. I) intimates that there is interdepen-
dence at all times between the quantity of money and global expenditure,
the coefficient relating thenz being a well-determinedfunction of past changes
in global expenditure. This result reconciles the apparently contradictory
conceptions of the quantity and antiquantity schools within a single formula-
tion.64
This interdependence also makes it possible to make conditional forecast-
ing. Knowledge of future nominal values of national income, if it would
be possible, could be used to produce predictions of future values of the
quantity of money, and vice versa.
5.8 Whatever the value of intuition as an instrument of research, the
only valid criterion for choosing between two different points of view is
to confront each theory with observed data. Naturally, this confrontation
does not show that desired cash balances MD / Dare effectively determined
solely by past changes in global expenditure, but it does show that the
record is what one would expect if they were. Obviously, this restriction
applies to any theory, of whatever type.
David Laidler has commented on our formulation in the following terms:
"To relate the nominal quantity of money demanded to some other variable
valued at current prices can also produce a misleadingly close relationship
between the variables.... This factor probably accounts for the results
reported by Allais for a demand for money equation using measured nominal
income and omitting the rate of interest."65 Laidler's reaction to the results
of the new theory is quite representative of that of many other economists.
It calls for four remarks.
Firstly, Laidler does not take into account the fact that equation (5.3)
specifically shows a relationship between desired money balances and the
psychological rate of interest.
Secondly, instead of yielding to the weight of the empirical evidence
63Relations 1.1 and 1.2 of Table 1 above.

640n the better results obtained with the consideration of PQ instead of P see Allais
[14], sec A5, pp. 443-44, and [15], pp. 450-51.
On the apparently contradictory conceptions of the quantity and antiquantity schools
see Allais [81, sec. 51, pp. 150-52; [9], pp. 1152-54, and [11], p. 10.
6sLaidler [94], p. -104, note 11.
and abandoning the current theories which lead to results which are much
less satisfactory and do not satisfy the stability criterion (see Sec. 5.1
above)-he remains faithful to them and is content to ascribe, without
any demonstration, the excellent results achieved using the new theory
of the effect of unspecified factors. Yet it would be necessary to show
how, for example, the extraordinary closeness of fit between the estimated
and the observed values of the money supply in the German hyperinflation
(r= 0.99979, 1 - r2 = 0.00042) is a "misleadingly close relationship."
It is not scientific to allege without proof. It is rather as if some eighteenth-
century physician favoring Descartes' vortex theory had rejected Newton's
theory because it did not refer to vortices, and attributed the extraordinary
success of Newtonian mechanics to some unspecified influence. Such is
the powerful ascendancy over minds of the theories to which they have
been long accustomed and which have literally conditioned them.
Thirdly, there is an extremely important point which Laidler completely
neglects. The hereditary relativistic theory has disclosed an invariant
structural relationship in the empirical data, which is verified remarkably
well for both hyperinflations and normal economic situations (see Sec.
5.1 above). This structural relation should be considered as an observed
datum, and as such is valid whatever judgment is passed on the hereditary
relativistic theory. It would remain a fact even if the new theory were rejected
altogether. So long as the currently accepted theories are incapable of
explaining the existence of this structural relation in the empirical data,
they must be considered as being contradicted by experience, and therefore
rejected as being misspecified.
In reality, for any theory to be acceptable, it should be able to explain
the relationship between the time series for global expenditure and the
money supply which the hereditary and relativistic theory has brought
to light and which is observed equally in the data for hyperinflationary
periods and in those for current economic situations.
It is worth recalling here that Newton's theory of universal gravity was
only accepted because it proved capable of explaining the empirical structural
relations which Kepler had demonstrated earlier.
Finally, the theory presented is surely not a definitive one. Like all its
predecessors, it too will have to be replaced when its turn comes by other
theories which will be more comprehensive, or nearer to reality. This is
the line of research to be pursued; it is more worthwhile than basically
* * . * . * - .
unJustlt :lec a prlorl crltlclsm.

In fact all the a priori objections presented against the new theory are
based on the same intuitive assumption that: "The results are too good
to be true." The reader can rest assured that this thought did not escape
the author and that he pondered for a long time.
In a recent article, Michael J. Hamburger notes that "there is some
indication that . . . monetary economics still suffers from an overdose
of intuition and casual empiricism.... The wide acceptance [of the usual
view] is based primarily on its intuitive appeal. It is hoped that the results
provided here will lead those economists who take this view either to
be more suspicious of their intuition or to provide some empirical evidence
to support it."66 This could not have been better said. The contemporary
literature is too often cluttered with assertions for which no trace of empirical
justification can be advanced and whose only real justification is their
endless repetition in innumerable text books.67 But instead of querying
their validity, attention is focused solely on their implications, and they
are used for economic policy prescriptions which ultimately determine the
fate of millions.
On the limited validity of a priori arguments, let us recall here the skeptical,
if not hostile, reception met by Planck's first publications on the quanta
theory. As unbelievable as his model may have appeared at that time,
it was nevertheless the one that finally proved itself true to reality. Planck's
example should make us very cautious with regard to the value of
assumptions, whose only value lies in the fact that we are used to them.68
VI. THE MINIMUM VALUE OF THE PSYCHOLOGICAL RATE OF INTEREST

AND THE LIQUIDITY TRAP
To the extent that the new theory is justified, and to repeat, in the
present state of our knowledge, the record reads as it would if the theory
were valid, the psychological rate of interest i defined by the relation69
= (6a1)
is always greater than
66M. J. Hamburger [97], p. 622.

67Such as, for example, the Hicks-Hansen ISLM theory of the determination of national
income which is religiously taught in all universities (see, e.g., Dernburg and MacDougall
[52], Chap. 9, pp. 118-22). This theory holds that full employment and a high level of
output imply maintenance of a low rate of interest. But it is based on a series of a priori
equations, none of which has any empirical justification. Theories of this kind rest on foundations
of sand and can be made to prove anything. They have nothing in common with true science.
The proliferation in the current literature of such models, deprived of all quantitative
verification, is to be deplored. Perhaps they contribute in certain cases to show the skill
of writers in handling mathematics, but on the economic level the only result is the instigation
of confusion. On this point, see also sec. 10 below in fine.
68On this question, see also Scadding [114] and my reply [19]. See also Cagan [36 and
40], and Allais [14], sec. A14 and [15], p. 453.
For the German hyperinflation, the correlation coefficient between log M and log M*
is 0.99979 instead of 0.9987 as indicated in Allais [8], p. 102 and [9], p. 1144; see also
69Relations (1.3) to (1.5) of Table 1 above.
2° = 2.4% p.a. (6.2)
Thus we have
i2 °. (6.3)
In economic terms, this relation implies that in nominal value, preference

for the present always exceeds io/2. This of course reinforces the views
of Bohm-Bawerk and Ludwig von Mises on the necessary preference for
the present as a base for an ever positive pure nominal rate of interest
(see Sec. 3 above).
In addition, relations (1.3) and (6.3) imply that
X 2 Xo/2, (6.4)
signifying that the rate of forgetfulness always exceeds a certain minimum

figure-in other words, that the effect of the past is always attenuated.
This is quite natural. From relation (6.3) it follows that the interdependence
of relative desired money balances MD/D and the psychological rate70
of interest i corresponds only to a segment of a hyperbola, as it is shown
in Fig. 1.
It further follows that whatever monetary policy is followed, and whatever
the rate of increase of the money supply, the psychological rate of interest
cannot fall below the value io/2. This of course does not mean that the
same is true of the monetary rate of interest as observed on markets.7l
There is an obvious analogy between this circumstance and the formulation
normally presented in the Keynesian literature of the "liquidity trap" (the
Keynesian Case).72 The meaning of condition (6.3) is that there is a "liquid-
ity trap" for the psychological rate of interest since, whatever the rate
of growth of the money supply, this rate always stands above a certain
threshold level.
The analogy is nonetheless a purely formal one as regards the rrionetary
rate of interest. It can only correspond to reality if the two conditions,
(a) M = MD and (b) monetary rate of interest in market transactions
- i, are satisfied, whereas they are not satisfied in general, mainly because
the marketmonetary rate of interest differs from the correspondingmonetary
70Relation (5.3) above.

71 See above, secs. 2 and 5.
72See Bronfenbrenner and Mayer, [29 and 30], Eisner [55], Meltzer [101], Dernburg
[51], Modigliani [105], and Brunner and Meltzer [32]. See also Harrod [81], pp. 370-71,
as well as Allais [lO], Vol. III, pp. 220-21.
REZAK/VE SES/wEO ovzr SAZArES

At/S DEERSt80Z06/CAt RAZR 0F/tEERDZ
_ I
D l l
l l
I
I
\\
\ I
\ I
\\\ I
&
FIG. 1
pure rate of interest by an amount corresponding to the liquidity premium

(see Sec. 2 above).
In any case, in relation to the market monetary rate of interest, the
assumption of a "liquidity trap" has never been seriously justified.73
VII. ESTIMATING THE VELOCITY OF CIRCULATION OF MONEY

FROM THE PSYCHOLOGICAL INTEREST RATE
Estimates of the money supply and of national income are available

for Great Britain from 1878 on.74 It is therefore possible to confront the
estimate of the demand for money that can be derived from the new
theory from the estimate of the psychological rate of interest, with observed
data for the velocity of circulation.
D
V= M. (relation(1.7) (7.1)
73See especially Laidler [93], and Brunner and Meltzer [32].

74See notes 82 and 83 below.
Since
D= KR, (relation 1.2) (7.2)
KR
M ' (7.3)
and therefore
VR = K S (7.4)
using VR to designate the quantity
R
VR= M, (7.5)
which represents the velocity of circulation with respect to income, the

income velocity of money.
In practices the coefficient K has risen slowly as the structure of the
economy has become more complex and specialized. As a result, the ratio
D/R of global expenditure to national income has risen steadily. As a
first approximation
K= Kl ePt-tt) (7.6)
can be written, where Kl represents the value of K for t - tl and where

p is a positive quantity.
If it is further assumed, at least as a first approximation, that M and
MD are nearly equal,75 the theory yields the relation76
D 1
MD O(Z) ( * )
Then, it follows from (7.4), (7.6), aIld (7.7) that the theory yields for the
income velocity of circulation VR the estimate77
75 Allais [ 17], sec. 23 *

76Relations (5.1) and (7.1) above.
77For a given value of Z, relation (7.8) shows that VR should decline secularly This
decline results from the rise of coefficient K (relation 7.6) as indicated above.
It results also from the progressive replacement of the bills of exchange as means of
payment by credit money during the nineteenth century. In the calculation the coefficient
p is taking account of these two effects.
It is quite strange, to say the least, that so simple and appealing explanations seem to
have been completely overlooked by the Chicago School, whose explanations are really not
VR zizOKleP(t-tl)\v* (Z) * (7.8)
Now, since78
i* 1
lo +(Z)' (7.9)
i*
4)OK1ioep( 1) (7.10)
and since79
i*
o F ' (7.11)
where i* is the estimate of j and where Fo is a constant, we can deduce

the expression
oKxio eP( 1) (7.12)
This last expression can be validly

VR.
Calculations already made give val
io = 4.8% Fo = 1.9. (7.13)
To calculate VR, the rate p and the pro

These estimates can be made by conside
i V
log ° R = _ P (t-t 1 )-log f oK1 + e e (7. 14)
Fol*
where e is a stochastic variable. This correlation is deduced from (7.12

by substitution of VR for VR.
satisfactory on this point (see for example M. Friedman [63], chap. 6, especially pp. 110
111, 127 and 136; Friedman and Schwartz [66], pp. 14, 96, 639 and 679-82. See also Chow
[47],pp.116-18).
78 Relation ( 1 3)
79Allais -17- , relation (33.9).
80Allais 17 , sec. 35 and Appendix 1, second last column.
81Relatia ns 4 1.3) and (1.5) above, and Allais [17], relation (35.1).
t i st t 14 *; j lNt-t -; - 1, L ^ f + P -, t-4 -i+ r-f z
i - | j- nittit t1 j
Nii; .+,, 1.**
+4t 'iil jlll
t lt' !tit ' ."ti 'itt ,,$ $ ! ::ti;
+ ;+ ' tati +t-'+tt t44t-'t 1'

;-t t 4, :litts,7. lt,4-$!§ s y
) !g ,'§ iet +roj§, ,. 7 Ita}at < + Hi! ! t
w t st('+it i+ .,t- - t- tiftlif tf t-t4Set i tfi1tii|
l 5 t+4 l,i+t it ' tztl r r tf i j +sFl- ti 1 1 l ' i
J {$ t;*!-+il} t f _ t&t- . _+1; it -t- ->;Lt 4!,. I'.i 1t iti l
*, j et tih ! I 1 { |, t 'i tifi; titl sli.

1r!§ D i! ! ti+
Illi ;' ;it
-e l l , 1 ,l;: 01. 1 i ll i W 1 2 1 0 0 t tX ttl ' 10 02+-ei WtX

i 4 iltlil,tiI 4li n l t-tii ilEt Ff-i 4;TI. 0J(; taiij +1 1 |XPA F i $ 1 ,4 -r 1- 1 til *i! -I tt 00:
-
- ;i4,tl;!lfti:,i - 4*til' rli I4ltl-i,+lil Xt !t1--1Fi1W1ll-1ll -i 1+1tl! rtl-llf,.i-t ilf'tt1l-11-^ @ -

| 'tt 0 ^ l->| ' . tt wI t .|11 1 4 + 1. ' tft 1 - -0 tL _it _t T t t l l 1 j_
For the money supply, estimates by Higonnet, based on figures in the

Economist from 1878 to 1910, have been taken, extended by Tinbergen's
estimates for 1911-14.82 Jefferys and Walters's estimates of national income
have been used for that quantity.83
82R. P. Higonnet [83], p. 330 (col. 2, values on right). The data are as at 31st December.
Higonnet gives: 1878, 510; . . .; 1910, 980; Tinbergen (as given in Higonnet): 1910, 977;
1911, 1018; . . . - 1914, 1298. Values as at 30th June have been estimated by linear interpolation
(see Appendix below).
83J. B. Jefferys and D. Walters [84], pp. 8 and 9, col. 2 (see Appendix I).
When the correlation in (7.14) is calculated for tl = 1879, it is found

that
p = 0. 182% (7. 15)
XoKl = 0.521.
The observed and calculated values of the income velocity of money

over time are plotted on a log scale in Chart II.84
Given the imperfections in the estimates of the items entering into the
calculations the verification of the theory is at least as good as might
have been hoped a priori.85 86
84The estimate VR is calculated from relation (7.12). As regards the calculation of V*

for the period (1815-78), the only course available was to extrapolate the rate p observed
for the period 1879-1913.
Of course from relation (7.10), the correlation between VR and VR shown in Chart II
is equivalent to a correlation between the ratio of the national income R to the money
supply Mand the psychological rate of interest i*.
From relations (7.10) and (4.9) we have then
j*f Ij*
XoKI io eP(t 1) (1)
which yields the approximative relation
j+ Ij
XoKl io eP(t tl) (2)
which shows the existence of a correlation between VR and j.

Actually, the studies made of the link between the velocity of circulation and the rate
of interest do not take the liquidity premium Ij into accountS and this omission may well
account for the anomulies observed (see the note 8 above and the references mentioned
in note 86 below).
In fact, to allow for the trend p, the calculations of the coefficient Z according to relations
(1.6) and (1.1) (Allais [17], secs. 34-36) should be repeated for the period 1879-1913, since
according to (7.2 and 7.6) we have
1 dR
x= + p (3)
R dt
whereas, in the calculation of j*, the rate p has not been taken into account. In view of
the relative smallness of the rate p, this correction would not change the above results
verv much.
§5The coefficient of correlation between log Vand log V* for the period 1879-1913 is
r= 0.814 (1 - r2 = 0.337)
The coefficient of correlation between log M and log M* where M* is defined as
M* = +0 Kl eP(t - tt) R+* (z) (1)
is higher still, its value being
r= 0.987 (1 - r2 = 0.026).
But of course
It shows that in the nineteenth century the link between the velocity
of circulation and past values of national income is exactly the same as
that observed for the various twentieth-century series examined previous-
ly.87 88 The structure of the hereditary relativistic model on which the new
theory is based can thus be seen to be basically stable.89
moy. [log M- log M*] = moy. [log VR- log VR] (2)
since
R R
log VR - log VR = log-- log-= log M* - log M. (3)
It should be noted that there is no lag between the VR and V*R curves. Taking into account
the results already obtained, this means that the yield on Consols, used as representing
the long-term rate of interest, is on average lagged 18 months behind the velocity of circulation
whereas the short-term rate of interest is lagged about 6 months behind it (see sec. 2 above).
86According to relation (7.12) the agreement between the estimated VR and the observed
VR values shows that there is a good correlation between j* and VR. Since the observed
yield j on British Consols is well correlated with j*, j and VR should be correlated.
In fact, for the period considered, we find the following results:
P r 1 - r2
Correlation 0 0.610 0.623
coefficient 1 0.645 0.584
j(t + p), VR(t) 2 0.655 0.570
3 0.612 0.625
4 0.544 0.704
The correlation coefficient seems to be highest for a lag of about 18 months.

These results may be compared with those found by Behrman [23], Ritter [115], Bernstein
[26], Latane [95] and [96], Chow [47], and Paish [109].
87Denoting the means and standard deviations of log V, and log V* by ml, m2, al
and C2, and by r the correlation coefficient between log VR and log VR, we have
e2 = average (log V,- log V,*)2 = (ml - m2)2 + al2 + a22 _ 2rala2.
We find
ml = 0.7439 m2 = 0-7440
al = 0.0413 C2 = 0-0595 r= 0.814
whence we derive
e2 = 0.00124 e= 0.035.
Thus the average deviation of the logarithms of the observed VR from those of the calculated
values of V* is of the order of 3.5 percent.
Thus the quality of the fit is wholly comparable to the best of the earlier results obtained;
the corresponding values for the USA for the period 1918-1941, for example, were
e2 = 0.00086 e= 0.0293
(Allais [8], pp. 102, 111 and 132; [9], pp. 1142-43 and [11], pp. 7 and 8).
88The values °f XoKl already found for the series studied in my preceding publications
(see note 87 above), compared with the value of 0.52 found for Great Britain for the period
1879-1913 (relation 7.15) are as follows:
It may be remarked that the computation of as* and j*, and therefore
that of VR, depends only on the observed values of the product90 W
= PQ, whereas that of VR ;S based solely on the observed values of
R and M. There is, it is true, close interdependence between the values
of the product PQ and those of R, but the essential point is that once
the values of the constants p and oKI have been chosen, the calculution
of VR on the basis of relation (7.8) is wholly independent of the values
- .,
OJ M.
Finally, since the values of j* are already given by the calculations

carried out earlier, the fitting corresponding to Chart II comprises two
degrees of freedom only corresponding to the two parameters p and PoK
VIII. MONETARY INFLATION AND THE PSYCHOLOGICAL RATE OF INrEREST
Since the beginning of the eighteenth century, at least, there has been
controversy over the link between the money supply and the rate of interest.
On one view, an increase in the money supply lowers the rate of interest,
on another, it raises it. The first view has generally been defended by
economists more or less favorable to iIlflation, the second by economists
who considered inflation undesirable. The debate has been all the more
impassioned in that considerable economic interests have always been at
.
ssue.
Both cumps have advanced excellent arguments which, on close investiga-
tion, appear not to be at all contradictory. In point of fact, an increase
in the money supply always produces an immediate decline in the monetary
rate of interest ruling on financial markets, since supply has expanded
with demand practically unchanged 9l However, the increased money supply
always ends up by triggering higher interest rates, since the increase in
global expenditure that it generates raises profits, and these in turn engender
Values °f XoKI
France Great Britain United States Averages
1898-1913 0.54 1879-1918 0.52 1898-1915 0.77 0.61
1919- 1938 0.66 1925- 1940 0.70 1918- 1941 0.93 0.76
1947- 1962 0.84 1952- 1962 0.48 1946- 1958 0.72 0.68
Averages 0.68 0.57 0.81 0.69
It is a striking fact that all these valxes are of the same order of magnitxde. In any
case, it is possible that their residual differences could be explained by differences in the
definition of M and R for individual countries.
It should be noted that the values of +0 given in my preceding papers [8] and [9] correspond
to the index numbers of M and R, and not to their absolute values (on this point see
also Allais [13], p. 414, note 112).
89This is clearly an essential finding in the light of contemporary debate (see note 48
above).
90Allais [ 17], sec. 32.
9'A similar phenomenon occurs if, through the credit mechanism, a fall in the monetary
rate of interest engenders an increase in the money supply.
an increase in the demand for capital, whence an increase in the demand

for money, and in turn, higher interest rates. As early as the beginning
of the eighteenth century, Cantillon in his admirable "Essay on the Nature
of Trade" described this mechanism perfectly as follows:
I consider in general that an increase of actual money causes in a State

a corresponding increase of consumption which gradually brings about in-
creased prices.... ff the abundance of money in the State comes from
the hands of money-lenders it will doubtless bring down the current rate
of interest by increasing the number of money-lenders: but if it comes from
the intervention of spenders it will have just the opposite effect and will
raise the rate of interest by increasing the number of Undertakers who will
have employment from this increased expense, and will need to borrow to
equip their business in all classes of interest.92
I propose to call this second effect the "Cantillon effect" so as to mark

the remarkable priority of this great economist. Most of what has been
said since has merely given rise to confusion;93 the effort would have
been better spent deepening Cantillon's too short but remarkable analysis.
More recently, the proponents of Keynesian doctrine have considered
it somewhat of a paradox that higher interest rates could accompany rapid
growth of the money supply.94 In Keynesian theory, an increase in the
rate of growth of the money supply should bring about lower interest
rate levels.95
In reality, the link between inflation and the rate of interest is very
complex and is characterized by actions and reactions in opposite directions.
As Irving Fisher noted so correctly, "To the extent that the interest rate
is the cause and price movements the effect, the relationship is the opposite
of that which holds when price movements are the cause and interest
rates the effect."96 In the first case, movements in the interest rate tend
to bring about movements in prices in the opposite direction, whereas
in the second, the changes in prices tend to be in the same direction as
those of the interest rate.
This produces major difficulties in any attempt to separate the two effects
by analysis of time series on the money supply and the monetary rate
of interest. E. W. Gibson notes that
interest rates can be lowered by increasing the money stock, but this act
also produces forces which will offset the lowering within several months.
92Cantillon [45], Second Part, chap. 6 (English edition, pp. 163 and 215; French edition,
pp.9landll8-19).
93See Charles Ristss excellent analysis ([114J, chap. 2, sec. 3, pp. 106-14; chap. 5, sec.
4, pp. 215-22; and chap. 7, pp. 285-320).
940n this paradox, see Allais [18] and sec 3 above in fine.
95According to Keynes [90], the level of interest rates depends on the quantity of money
(chap. 13, sec. 2), and full employment requires lower interest rates (chap. 21, sec. 7).
Keynes had already put forward this idea in [89] (1935 edition, pp. 207-8 and 383-87).
96I. Fisher [61], chap. 19, sec. 2. See also Wicksell, English edition [122], Vol. II, p.
208.
This process will produce increases in nominal income (and perhaps in prices),
which may be a goal of monetary policy. But the sequence clearly makes
it hazardous to view the levels or changes of interest rates as indicators
of monetary policy. Since income increases due to money stock increases
will be accompanied by higher interest rates, interest rates can as well be
regarded as reflecting an easier as a tighter monetary policy. Moreover, to
maintain lower interest rates it is necessary to increase money stocks
continuously. But this act itself generates expectations of rising prices that
tend to raise interest rates.97
The formulation of the demand for money proposed here leads to the
finding that for a given level of global expenditure, the psychological rate
of interest is inversely proportional to desired money balances.98 It follows
that to the extent that desired money balances differ little from the money
supply and that the pure rate of interest iM corresponding to the market
monetary rate of interest differs little from the psychological interest rate,
then, for any given level of global expenditure, the money supply and the
market monetary rate move in opposite directions. Further, it is certain
that an increase in the market rate of interest immediately tends to reduce
the money supply and vice versa.
If, however, the market monetary rate of interest is set too low by
reason of monetary policy measures, the money supply will tend to exceed
the level of desired money balances. This will generate inflationary pressure
which will in turn raise the level of global expenditure. The present
formulation indicates that this will raise the coefficient of psychological
expansion99 Z and ultimately, therefore, the psychological rate of interest.
Since a major discrepancy between the psychological and pure monetary
rates of interest cannot persist indefinitely, the end result will be an increase
in the market monetary rate of interest, reversing the downward movement
of this rate in the early stages of the process.
The conclusion is that any attempt to keep the market monetary rate
of interest below the level corresponding to the psychological rate of interest,l°°
which is determined by past movements in global expenditure, can only
result in inflation.l°l
The only way the market monetary rate of interest can be kept low
is to expand credit facilities, so producing an increase in the money
supply and, therefore, in global expenditure. The effect is to raise the
coefficient Zof psychological expansion, and consequently the psychological
rate of interest, which sooner or later will bring about an increase in the
97E. W. Gibson [71], p. 453. On this point see also E. W. Gibson [70] and Cagan and
Gandolfi [43]. See also sec. 10 below.
98Relation (5-3)-
99Relations (1.1) and (1.2) above.
I°°Allowing for the liquidity premium corresponding to the monetary rate of interest (see
sec. 2 above).
101 A similar point of view was put forward by Wicksell in his famous article "The Influence
of the Rate of Interest on Prices" [123].
marketmonetary rate of interest.l02 If the monetary authorities then attempt

to combat the rise in interest levels by further easing credit, they merely
give a further twist to the inflationary spiral, bringing about a further
rise in the psychological interest rate and a renewed upward thrust to
the market monetary rate of interest.
In fact, any attempt to stabilize the market monetary interest rate at
a level other than that corresponding to the psychological interest rate
will bring about either inflation or deflation, depending on whether the
corresponding pure monetary rate of interestl03 is below or above the
psychological rate.
A consequence is that the Central Bank, notwithstanding its ability to
act at any given moment on the market monetary rate of interest, cannot
control the psychological rate.l04
Whatever the complexity of the causal chain, the fact remains and
it is a fundumentul one --that an increase in the money supply, by whatever
means it is brought about, always generates an increase inglobal expenditure,
the emergence of profits,l05 increased demandfor loanfunds, and ultimately,
an increase in the rate of interest.l06
Lucid economists have always seen this clearly. Rist, for example,
analyzing the long-term rise in the rate of interest that occurred from
1896, followed the lead set by Cantillon when he wrote in 1913:
The proximate cause of the rise in interest is the increase in industrial profits
over the past 1S years. But why did profits rise? was this not a simple
consequence? and if so, of what? No doubt, of rising prices. This is the
major feature, the most notable of the past 1S years, and it has set its
seal on our epoch (just as falling prices characterised the period 1874-1896),
and we find its influence here: the rise in interest rates accompanies the
rise in profits. The two phenomena are associated: the rise in prices is the
lever by which one acts on the other, but the basic cause is the rise in
prices. 107
I believe that Irving Fisher was wrong to attribute the rise in interest
rates to operators' desire to compensate for rising prices, and I think
that Macaulay's criticisms were highly pertinent.l°8 Unfortunately, these
'02By reason of the interdependence of the various rates of interest.

See sec. 2 above.
l04Since the psychological rate of interest depends only on past changes in global expenditure,
which must be taken as a datum at the moment under consideration.
This is not to suggest that the Central Bank cannot act on the future psychological rate
of interest by an appropriate expansion of global expenditure.
1050n the emergence of profits as a consequence of an increase in global expenditure,
see Allais [10], Vol. 1, pp. 16-38, and [15], p. 450.
I060n the various aspects of this process, it is interesting to compare the analysis of
different authors. See for example Wicksell [122], Vol. II, pp. 168-208; I. Fisher [61],
1935 edition, Vol. II, pp. 198-208; Macaulay [100], chap. 6, and Cagan [37], pp. 252-59
and 305-9.
7Charles Rist [ 113], p. 3 18.
Fisher [61], chap. 19 and Macaulay [100], chap. 6, pp. 189-208.
criticisms have been ignored (although it is hard to see why), and Fisher's
point of view seems to be accepted by most economists (see for example
the various publications of Cagan and Friedman on the rate of interest,
and the studies published by the Bank of St. Louis). On this approach,
the real rate of interest (i - p, where p is the rate of increase of prices)
tends to remain constant in a dynamic process. The theory put forward
in this article suggests instead that the real rate of interest changes when
prices change (see Sec. 9.4 below).
The preceding analysis sheds light on an aspect of the connection between
the rate of interest and the price level. 109 The various pure rates of interest
tend to equalize, aligning themselves on the psychological rate of interest.
Since an increase in the money supply always results in higher global
expenditurell° and higher global expenditure brings about an increase in
the psychological rate of interest,lll it follows that in itself any increase
in the money supply will tend finally to engender an increase in the level
of the interest rate.
There is no contradiction between this and the fact that in a dynamic
equilibrium, where M= MD' we havell2
iM/D= Xofo (1)
For although this relation implies that, for a given value of D, i will decline
when M rises, this is no longer true when global expenditure D rises faster
than Mby reason of the relation
1 1+eZ
D=- M, (2)
+0 2
which follows, for M= MDS from relation (5.1), allowing for the relations
(1.5) and the link between the coefficient Z and the rate of growth of
global expenditure (relations 1.1 and 1.2).
Therefore, in the framework of the new theory, it is perfectly clear that
there is no contradiction between the negative correlation of the money
supply and the interest rate in the short term and the positive correlation
between these same quantities in the long term.
These considerations suggest the conclusion that the most appropriate
regulator available to the monetary policy authorities is not the interest
rate, but the overall level of the money supply.ll3
09On the link between the rate of interest and the price level, see Allais [18].
Il°See Allais [8], pp. 150-52, and [9], pp. 1152-54.
t1lThis follows from relations (1.1) to (1.4) of Table 1 above.
Relation 5.5.
13From this point of view, the controversies of the past twenty years and the very recent
surge of debate on monetary policy and rising world-interest rates take on even greater
IX. GROWTH AND INFLATION
9.1 I have shown in various studies of the efficiency of the capitalistic

processll4 that in dynamic equilibrium, the ratio of real national income
to its possible maximum at any given moment is a function
F= F(u) (9.1)
of the rate
u= i- x, (9.2)
which is the excess of the nominal psychological rate of interest over

the rate of growth of nominal national income,ll5 and that this function
F(u) passes through a maximum forll6
u = O . (9.3)
I have suggested that the rate u be referred to as "the relative rate of

interest."
The theory of capital I have presented can be used to specify the function
F(u) operutionally 117
9.2 A major advantage of the new theory of the demand for money
is its provision of an expression for the nominal psychological rate of
interest i as a function of x in a dynumic equilibrium process.
In such a process we have
-= O (9.4)
dt
significance (see especially Ball [22], chap. 11, especially pp. 277-83; E. W. Gibson [70
and 71]- Fand [57 and 58], F*st National City Bank [59], Economist [54] Friedman [63],
chap. 5, and [64]; Friedman and Heller [65]; Leach [97]; Pierce [110]; and Hicks [82].
4Allais [5, 6, 7 and 13].
I'5The contemporary literature is unanimous in suggesting that the relevant variable for
analysis of this question is the real rate of interest i - p, the excess of the nominal rate
of interest over the rate of price increase. In fact both theoretical analysis and the empirical
evidence suggest that the relevant quantity is the relative rate of interest i - x, given as
the nominal psychological rate of interest i less the rate of increase x of global expenditure
(see above sec. 5.6, and Allais [5, 6, and 13, secs. AS and A13]).
1l6This is a first-ordercondition, wholly independent of any convexity condition (see Allais
[6], pp. 82-83).
"7See Allais [13], pp. 400-2. In this respect, this theory of capital is far superior to
the other formulations in the literature, which are not operational.
so that from relations (1.3) and (1.6)118
x= iz. (9.5)
Now, from relation (3.1)
i l+eZ
_= (9-6)
io 2
whence
( io )
and, from relation (9.5),119
g (io ) (9.8)
so that finally, from (9.2)
U= i 1 _1og(2i_ 1) (99)
These two equations (9.8) and (9.9) allow for the determination of the
function
u= u(x), (9.10)
which gives the relative rate of interest in terms of the rate of increase
of global expenditure.
9.3 Relations (9.1), (9.8), and (9.9) then allow of a thorough analysis
of the incidence of inflation on the level of output in a dynamic equilibrium
process. 120 This analysis can be completed by simultaneously taking account
of the utility of consumable production and the utility of cash balances,l2l
which in turn enables the optimum level at any given moment of the money
supply in a dynamic equilibrium process to be determined.l22 Insofar as
'18Table 1.
"9See Allais [13], relation (B 20).
'20Allais [13], pp. 404-9.
121 Allais [13], pp. 411-22.
'22Allais [131, pp. 389-94. The reader will find it useful to compare the analysis in my
1968 paper [13] with Friedman's approach in 1969 [63], chap. 1, "The Optimum Quantity
of Money", and Jerome Stein's critical analysis [117] under the same title. See also Mundell
[107] and Cagan [39].
applications are concerned, the main result of this analysis is to demonstrate

that generallyl23 the real income gains available from lowering the relative
rate of interest u are substantially overstated.l24
9.4 A consequence of the relation (9.8) is that in a dynamic equilibrium
we have
i=io for x=O. (9.11)
Writing
i = io + i\i, (9.12)
we have
x = (io + i\i) log (1 + . ) (9.13)
so that, in the neighborhood of the value i = i
x p q
i\i 2=2+2; (9.14)
and thus
x P q
u = i-X io +-= iot----' (9.15)
where p and q respectively denote the rate of growth of prices and production.
Thus we have
° 2 2 * (9. 16)
This stands in contrast with the relation
i = io + P (9. 17)
23By reason of relation (9.1). See Allais, [13], pp. 389-94, 405-9 and 415-20. In fact,
we have
F(u)= 1-Ku2 (1)
where K is a constant whose order of magnitude is estimated to lie in the range 10 to

30 (Allais [13], p. 401 and 409, note 97).
'24See, for example, Keynes [90], chap. 16.
currently accepted in the literature (see Sec. 8 abov

Evidently we could expect a priori that the inc
rate of interest will compensate exactly for price i
took this as his starting point. However, it turn
there is only partial offset. It follows that operators
with what we could expect a priori of their behavior
It should of course be noted that as q is genera
q/2 in relation (9.16) entails partial compensatio
a dynamic equilibrium in which p and q are equa
be equivalent to relation (9.17).
Finally, although A q is correlated with i\ p in cyclical fluctuations this
property is of no value here since the processes being considered are
those of dynamic equilibrium, in which conjunctural fluctuations are assumed
absent by definition.
X THE RATE OF INTEREST AND THE RATE OF FORGETFULNESS
The concept of the rate of forgetfulness underlying the present theory

is new, and to the extent that it clashes with established habits of thought,
there may be some unwillingness to consider its implications, or usefulness.
But it should be recognized that the mechanism of the memory as portrayed
in the new theory is no more complex than that of the discounting process,
which is generally accepted and understood nowadays. On reflection, it
will no doubt be acknowledged that the theory proposed here, which unifies
memory and discounting, is no more than an accurate formulation of an
everyday observation, namely, that those whose memory of their past
experience is best are also those who take most account of the future.
Recollection goes hand in hand with foresight.l26
The proposed formulation is based on consideration of a forgetfulness
of past events which in normal circumstances is close to an exponential
rate of memory decay.l27 It is no objection to observe that sometimes
l25See the highly pertinent criticism of Fisher's position by Macaulay [100], chap. 6,
pp. 189-208.
t26See Allais [13], p. 462.
'27If referred to the psych
as the reciprocal of the a
the collectivity, since
rX
| o e- XoodO
Jo
t e - XoodH
For XO - 0.004 per month, or about 5 percent per year, OO = 20 years meaning that o
average, society takes account of the past up to distances in time of about 20 years.
one remembers an event far back in time better than som

yesterday,l28 for obviously the intensity with which h
themselves on our minds must be taken into account. This objection is
no more valid than the rejection of the exponential process in discounting
on the grounds that one may prefer a billion dollars in 10 years time
to ten dollars tomorrow.
It is indeed strange that, despite their manifest importance, hereditary
phenomena should in general have received so little attention, not to say
total neglect. However it is the generality of hereditary effects which explains
the success with which autoregressive models have been used for the analysis
of economic time series. 129 It also explains the success of Fisher's empirical
distributed-lag formulation for the analysis of interest rates and other
economic magnitudes. 130 And it accounts for the successful use of expon-en-
tially smoothed series in forecasting.l3l
However, the absence of a sufficiently comprehensive theory can ulti-
mately lead to some strange errors, and without an explicit model to specify
the fading effect of a variable with the passage of time, the regression
models in general use are not suited to bring the real structure of these
effects to light. A simple regression equation, significant or not, cannot
disclose a causal relationship: it can only detect interdependence. This is
where the explanation must be sought for the quasi-periodic pattern of
the so-called "coefficients of influence" which are found, but which cannot
in fact mea3ure the influence they seek to quantify. What they measure
is the strength of the interdependence link during conjunctural fluctuations.
To obtain a clear view of the nature of the mistake that is made, consider
a model one of whose equations is of the type
rt
v(t)= KJ u(X)e-X(t-T)dT (1)
_x
'28See Allais [ 13], p. 462.

'29See Allais [8], sec. 4, pp. 21-22.
30See Irving Fisher [61], chap. 9 Koyck 91 * Griliches [73], Wold [125], Allais [12].
'3'See in particular Winters |12i]- Cox 250 1- Brown and Meyer [311- d'Esopo [56]-
Dobben de Bruyn [53]; Theil and Wage [1 8] Nerlove and Wage [108X, Harrison [80],
Kaufmann and Groboillot [85]; Mincer [102].
The exponential smoothing of a quantity y is based on a formula of the type
dz
= A (y-z) (1)
dt
where z is the smoothed value and A a constant. It is a remarkable fact that in computations,
the value of A is often found to be in the region of 0.1, which is the same order of magnitude
as the value X = X0/+(Z) for values of +(Z) of the order of 0.5, which mainly tend to
characterize normal situations (see Allais [8], p. 124, and [9], p. 1148).
The new theory of the demand for money rests on a much more general formulation
than relation (1), since the rate of forgetfulness X varies over time (relation 1.2 and 1.6)
and,it should usually allow a considerable improvement of the results obtained by the method
of the exponential smoothing (on this point see Mincer [ 102] .
analogous to equation (1.2) of Table 1, where ,B is a constant. Suppose

that a periodic solution of the model of the form
u(t) = sin X t (2)
does exist. There then follows
v(t) = sin@(t- 0),

get2 + 2 (3)
with 132
tg@o= .
(4)
Then for
,8 = 0.05 t = 4 years
we have
o = 0.98 years .
Thus the lag between cause and effect is only a year or so, whereas
the weighting coefficients decline fairly slowly, since
e-a(t-T)=0.60 for t-X=10
= 0.08 for t- = 50
indicating that their influence is reduced by only 40 percent after 10 years

and still remains at some 10 percent after 50 years. Thus, contrary to
what is suggested by certain works,l33 there is no contradiction between
lags of the order of one year and the maintenance of influence during
several tens of years.
It should also be noted that in the case considered, the coefficient of
correlation between v(t) and u(t - 8) is
r= cos (8- 0).
133For instance Yohe and Karnosky [126], and Cagan and Gandolfi [43].
322 ; MONEY, CREDIT, AND BANKING
It follows that the coefficients of correlation between v(t) and u(t -

8) fail to give any idea of the real "coefficients of influence" e-a8, and
that the straightforward interpretation of a statistical regression analysis
leads to wrong findings.l34 The same will occur if the coefficients are
subjected a priori to a polynomial law and specified to be zero at either
end of the period considered, according to the technique used by Shirley
Almon.l35 It is striking how many authors commit errors of this kind.l36
The specific advantage of the new theory is that it provides a model
setting forth the effective structure of hereditary influences (see relations
1.2 and 1.6 above).
The distinction between the psychological time scale and physical tim
corresponds simply to a transformation of the time scale so as to rende
certain relations invariant. The analogy between the theory proposed h
and the theory of relativity is clear; and although different fields are
concerned, the consideration of psychological time meets the same need
as the consideration of ds2 in the theory of relativity.l37
In point of fact, many authors, taking different approaches, have intro-
duced and discussed the concept of memory into the human sciences,
and some at least have considered a time reference scale other than that
of physical time. 138,139
Many have contended, and continue to contend, that it is absolutely
unlikely that events ten or twenty years distant in the past could still
have any influence today. Irving Fisher himself writes in his Theory of
Interest: "It seems fantastic, at first glance, to ascribe to events which
occurred last century any influence affecting the rate of interest today.
And yet that is what the correlations with distributed effects of price
changes show." l40
It cannot be contested that movements in prices and interest rates at
any given moment of time are the direct consequence of supply and demand
conditions at that moment. But these are in turn largely, if not entirely,
dominated by the psychology of operators, whose attitudes are formed slowly,
through a long process whose influence in our society is damped only very
slowly with the passage of time. It is in this area that we must seek the
essential reason for the length of the period during which the events of
a given epoch continue to influence subsequent events.
'34See for example Cagan and Gandolf; [43].

l35ShirleY Almon [20]-
'36See for example Andersen and Jordan [21]; Yohe and Karnosky [126]; Cagan and
Gandolfi [43]; Keran [86].
37 See Allais [8], pp. 23-25.
138In chronological order s
[11191; Cohen [48]; Caire [44].
13 The transformation of the time scale put forward and used for the study of econom
cycles by the NBER should be mentioned. It is motivated by a similar concern: the sear
for a transformation of the time scale under which structural laws become invariant (S
Burns and Mitchell [34], chap. 5, sec. 6).
I40Irving Fisher [61], chap. 19, sec. 7.
In reality, the influence of the past is comprehen

or collective phenomenon of memory as easily as t
to take account of income arising in the remote fu
or collective when it is carried out by the market
old man planting trees may be considered as acting
economically speaking. He will be long dead when
advantageous to fell them, but he can sell his plan
or even next week. In this case it is the market w
income into account. Similarly the memory of pas
down to us collectively through books, eyewitness accounts, or, less
apparently but just as effectively, through the successive impact of an
evolving social fabric. All these events, however remote, act on our
contemporary psychological attitudes, even if we have never participated
in or witnessed the events concerned. In any case, the verification of
the theory presented above indicates that the results are what one would
expect them to be if the hereditary influence of the past were manifested
over a long span of years.l4l
Because the new theory grounds its analysis on the hereditary influence
of the past, it stands in contrast to those contemporary theories which
base their reasoning on anticipation of the future. Of course the new theory
does not deny the important role played by anticipation, but it holds that
any anticipation of thefuture is strongly influenced by the hereditary influence
of the past, and that, this being so, it is this influence which is the motor
force of the dynamic development of the economy, with anticipation of
the future acting only as an intermediary factor.l42 In point of fact, men
can behave rationally only in terms of their past experience. Without that
experience, we leave the realm of science and enter the fields of divination
and fortune telling.
Be this as it may, the quantities which modern authors label as "expected"
are expected in name only. A kind of mythology has been built up, and
the most elementary analysis of a process of accelerated inflation is enough
to invalidate any such assertion.l43
Of course this proposition does not mean that there is no utility in
considering magnitudes that are labeled as "expected." Calculated as they
are calculated at present,l44 their usefulness is abundantly proved by the
14' Since the present is conditioned by the past, there is the paradoxical effect that people's
"happiness" depends on their memory of the past and not on their discounting of the future
so that a policy for bringing about a collective optimum should take into account not the
future developments, but the past evolution.
'42Allais [8], sec. 65, p. 175, and [9], p. 1155. See also Allais [13], sec. A3, p. 443,
and [ 15], pp. 451-52.
G. Haberler noted as long ago as 1937 that a theory based on the consideration of expected
quantities is devoid of interest if the expected quantities are not derived from facts observed
earlier (see [75], 1937 French edition, chap. 8, sec. 6, pp. 285-86.
43 See Allais [ 17], note 22.
44Relation 1 of note 131.
many fruitful economic applications they have engendered; but these

quantities are not the quantities they are thought to be, that is, expected
quantities. They are merely-psychological magnitudes representing the past
experience of economic operators.
APPENDIX I
GREAT BUTAIN
1879- 1913
NAMONAL INCOME, MONEY SUPPLY, AND OBSERVED

AMD CALCULATED VALUES OF THE INCOME
VELOCELY OF CERCULAMON (SEC.7)
National Money
Income Supply VR
R M [= (1)/(2)] VR
YearS (1) (2) (3) (4)
1879 1051 520 2.02 2.06

1880 1104 515 2.14 2.31
1 1144 520 2.20 2.24
2 1188 555 2.14 2.27
3 1216 570 2.13 2.25
4 1169 570 2.05 2.10
5 1149 565 2.03 1.99
6 1164 565 2.06 1.93
7 1193 575 2.07 1.94
8 1276 595 2.14 2.05
9 1364 625 2.18 2.13
1890 1431 655 2.18 2.11
1 1419 680 2.09 2.10
2 1393 690 2.02 1.97
3 1360 685 1.99 1.93
4 1406 695 - 2.02 1.91
5 1472 740 1.99 1.93
6 1500 775 1.94 1.95
7 1551 785 1.98 1.97
8 1633 805 2.03 2.03
9 1706 830 -2.06 2.13
1900 1791 845 2.12 2.23
1 1759 850 2.07 2.10
2 1775 860 2.06 2.09
3 1751 860 2.07 2.07
4 1779 850 2.09 2.06
5 1857 860 2.16 2.14
6 1978 880 2.25 2.25
7 2076 895 2.32 2.30
8 1967 915 2.15 2.07
9 2016 940 2.14 2.10
1910 2108 965 2.18 2.17
1 2185 999 2.19 2.23
2 2318 1038 2.23 2.29
1913 2424 1085 2.23 2.38
(1), (2). £ millions. The estimates for M are as of end June.

(4) relations (7.12) and (7.15). For j*, see Allais [ 17], Appendix 1, second last column.
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The Psychological Rate of Interest

Author(s): Maurice Allais

The ideas and the theories of our predecessors should not

Claude Bernard, Introduction to the

The Psychological Rate of Interest

In an earlier article, "Forgetfulness and Interest,"2 I showed how the

2AIIaaUisde[ s7eJrnard [25], pp. 74 75

MAURICE FELIX CHARLES ALLAIS is professor of economic analysis at the Ecole

THE NEW THEORY

Main Definitions and Notation

M = Money balances actually held (the money supply)

the money supply, prices, production, and

II. THE DIFFERENT RATES OF INTEREST

Economic analysis should distinguish at least three rates of interest;

discount the future,6 the pure short-term rate of

using ic to designate the corres

il = il + ll + Fl- pl, (2.2)

where il, ll, ,ul, and Pl respectively de

pure interest rates corresponding to given investments

in which e can be conside

Insofar as it is justifiable to suppose that

Ij= Aj, (2.6)

where A is a constant, there follows

3Allais [17], Sec. 33, relation (33.2).

rate of interest,l920 it is a noteworthy finding that the market short-term

III. THE EPRESSION FOR THE PSYCHOLOGICAL RATE OF INTEREST

lo t(Z) 2 ' (3.1)

9Allais [17], Sec. 35 and Chart II. We have:

where Zcorresponds to the calculated value in Sec. 34 of [17].

The coefficient of correlation between k(t) and i*(t) is 0.668 (1 - r2 = 0.554) to be

wii ;-}T iteTt' g .-t & .

64+ j5 ^ 2 2 2 w * X -H ' H . i't,X,;., ' g

-- _;_x: F_FrUr- _ r rogr wr

4 + +r +_ = - t< - t r_ f t ;e E i + + t J t t t r t i ; 1 f . i ff + t F e +tt-i i i 4 i ft i y i t ; ft t ft t t j i y j t \ ; ; ; ij i t H ; i + X ; i i i t_g

5 +ttifStie |'rt tfX

t, - t-4-e-t F i 1 li tl. t.,| f[, t 91t0 jit , t | ti . i

Xtt-'.04-'C'4Filxt',',l! ITL31tWt eL0.,+i t ;

titli;ttFtint; tttti4+t-1++tt;2Xt jtX t- .4 i t t-AW __

io = 4.8% per annum (3.2)

io = 12 X0 = 12. 0.004 = 4.85S,

the unit of time being the year.

t* 0.045 for the first half of 1923;

t* 0.0065 for August-September 1923.

And from equation (3.1) the corresponding psychological rates of interest

i = 4.8/0.0065 = 740% per annum.

Both estimates are of the same order of magnitude as Keynes's appraisal

IV. THE LIQUIDITY PREMIUM ON BRITISH CONSOLS

In the present state of our knowledge, it is no easy task to specify

in which lo and ,u are two constants and n may be considered as a stochastic

i-j=lo+>(i- io)+ N-6 (4.2)

The parameter ij here can be considered as the pare rate of interest

i* = 1.67 j + 0.0081 (4.7)

to which the corresponding values of A, jO, ,u respectively are, from (4.5)

where jO is the value of j for z = o.41

Ij= i* - j + e- {', (4.9)

and, using (4.7):

Ij = 0.67 j + 0.0081 + o (4.10)

in which o can be considered as a random variable.

39It seems perfectly feasible to assume linearity, at least as a first approximation.

r= 0.772 and 1 - r2 = 0.404.

4lIn fact, we have

Using (3.2) and (4.8), equation (4.7) can be written altern