Understanding Gibson's Paradox

Abstract

Gibson’s paradox has confounded economists for decades. Observing data regarding interest rates and inflation over hundreds of years, the prediction that interest rates and inflation would be positively correlated has proven false. Stranger yet, the predicted correlation actually does hold true and the paradox fades away when countries have abandoned the gold standard, only for it to return without explanation. Alfred Herbert Gibson, who first noted the paradox and for whom it is named, attempted to resolve the paradox by theorizing that the correlation. Would be delayed as interest rates would slowly react to the inflation rate. John Maynard Keynes and Milton Friedman, perhaps the two biggest names in economics in the twentieth century, also attempted to resolve the paradox with different theories. Alas, the data has not supported any of the theories proposed. This project proposes a new revision to Irving Fisher’s original theory in an attempt to explain some of the fluctuations of interest rates over the past two centuries.