Gibson's Paradox and the Natural Rate of Interest

Gibson’s paradox–the strong positive correlation between the price level and long-term nominal interest rates observed under the Gold Standard–is not inherently linked to the Gold Standard per se. Rather, it originates from low-frequency movements in the natural rate of interest (commonly referred to as R*) under monetary regimes in which inflation is strongly mean-reverting and has an approximately zero mean. While the Gold Standard is the only historical instance of such a regime, Gibson’s paradox can in principle emerge under a broader class of monetary arrangements. Indeed, once the deterministic component of the price level’s drift is removed, the same co-movement patterns can be recovered from data generated under contemporary inflation-targeting regimes. In line with the inefficiencies highlighted by the literature on metallic standards, this finding suggests that modern regimes are not immune to criticism, as fluctuations in R* account for significant portions of the variation of inflation and output.