THE THEORY OF INTEREST

are subject to what may be called “the money illusion,”and think instinctively of money as constant and inca-pable of appreciation or depreciation. Yet it may betrue that they do take account, to some extent at least,even if unconsciously, of a change in the buying power ofmoney, under guise of a change in the level of prices ingeneral. If the price level falls in such a way that theymay expect for themselves a shrinking margin of profit,they will be cautious about borrowing unless interestfalls, and this very unwillingness to borrow, lesseningthe demand in the money market, will tend to bringinterest down. On the other hand, if inflation is going on,they will scent rising prices ahead and so rising moneyprofits, and will be stimulated to borrow unless the rateof interest rises enough to discourage them, and theirwillingness to borrow will itself tend to raise interest.

And today especially, foresight is clearer and moreprevalent than ever before. The business man makes adefinite effort to look ahead not only as to his own par-ticular business but as to general business conditions,including the trend of prices.

Evidence that an expected change in the price leveldoes have an effect on the money rate of interest may beobtained from several sources. During the free-silveragitation of 1895 and 1896, municipalities could sell goldbonds on better terms than currency bonds. There was astrong desire on the part of lenders to insert a gold clausein their contracts, and to secure it they were willing toyield something in the interest rate.

The same tendency was strikingly shown in California during the inflation period of the Civil War. 1 For a time,

1 Moses, Bernard, Legal Tender Notes in California, Quarterly Journalof Economics, October, 1892, p. 15.

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