Wicksell's starting point was an attempt to reformulate the quantity theory of money from the neoclassical perspective.

As the author of On Value, Capital and Rent , which successfully integrated Walrasian general equilibrium theory and Bohm-Bawerkian capital theory, Wicksell was too good a neoclassical economist to accept the mechanical manner in which quantity theory relates the general price level to the total quantity of money in circulation. Instead, he proposed to explain the general movement of prices based on “detailed investigations into the causes of price changes. ¹ He thus began by reiterating the neoclassical law of supply and demand that “every rise and fall in the price of a particular commodity presupposes a disturbance of the equilibrium between the supply of and demand for that commodity, whether the disturbance has actually taken place or is merely prospective,” and then claimed that “what is true—in this respect—of each commodity separately must doubtless be true of all commodities collectively.” If there is a general rise in prices, Wicksell insisted, it is “only conceivable on the supposition that the general demand has for some reason become, or is expected to become, greater than the supply.”

This proved a decisive step. For Wicksell realized that this was tantamount to the refutation of Say's law, to which he, along with the rest of the classical and neoclassical schools, had faithfully subscribed. Nevertheless, he proceeded to study what happens when the intermediation of money has driven a wedge between aggregate demand and aggregate supply. ² As a faithful student of Bohm-Bawerkian capital theory, Wicksell singled out the rate of interest as the key variable that determines the relationship between aggregate demand and aggregate supply. He then introduced the concept of the natural rate of interest—a rate of interest that equates aggregate demand and aggregate supply—contrasting this with the market rate of interest quoted daily in financial markets. ³ When the market rate is left lower than the natural rate, aggregate demand is excessively stimulated and tends to exceed aggregate supply. Conversely, when the market rate remains above the natural rate, aggregate demand is choked off and tends to fall short of aggregate supply.

What Wicksell found in his analysis of the general movement of prices represented a new “macroeconomic” phenomenon, one that cannot be reduced to a mere aggregation of individual price-formation processes. He claimed that a general rise or fall in prices is a “fundamentally different phenomenon” from an isolated rise or fall in individual price. Since the demand and supply of a particular commodity is a function of its relative price—the former being a decreasing function and the latter an increasing function—an increase in its price will work to rectify a market disequilibrium by discouraging demand and stimulating supply, so long as it is not followed by others. But what is possible for an individual commodity in isolation may not be possible for all commodities at once. Whenever there is a positive gap between aggregate demand and aggregate supply, it follows as an arithmetic fact that most producers must experience excess demand for their products. They therefore simultaneously attempt to raise the relative prices of their products. No matter how rational they may be, their intentions are not mutually compatible. It is arithmetically impossible for all the “relative prices” to increase simultaneously! Indeed, as long as producers cannot observe the prices set by others in advance, all each producer can do is to raise his own prices relative to his expectations of the prices that others will set. (To simplify the argument, I will represent each product’s relative price by the ratio of its price to the general price level.) Since the general price level is no more than the average of individual prices across the economy, simultaneous attempts by a majority of producers to raise their prices relative to their expectations of the general price level will necessarily cause the general price level to go up relative to their expectations. What does this mean? Most producers will find out at the end of the day that the general price level has gone up unexpectedly . In contradistinction to the so-called rational-expectation hypothesis in neoclassical economics, whenever there is disequilibrium between aggregate demand and aggregate supply, errors in expectations are generated endogenously as the aggregate outcome of individual producers’ pricing decisions !

Once they realize that they have underestimated the general price level, most producers will revise their expectations upward. But such revisions will be of little help. For as long as there is a positive gap between aggregate demand and aggregate supply, most producers will again simultaneously raise their own prices relative to their revised expectations of the general price level. And, of course, their simultaneous bidding up of their prices will inevitably betray their intentions of realigning the relative prices, and the general price level will increase unexpectedly again. Further upward revisions of the expected general price level and an equally large increase in the actual general price level will follow. Wicksell was therefore able to conclude that:

If, for any reason whatever, the average rate of interest is set and maintained below the normal rate [i.e., the aggregate demand is set and maintained above the aggregate supply], no matter how small the gap, prices will rise and will go on rising; or if they were already in the process of falling, they will fall more slowly and eventually began to rise. If, on the other hand, the rate of interest is maintained no matter how little above the current level of the natural rate [i.e., the aggregate demand is maintained below the aggregate supply], prices will fall continuously and without limit. ( Interest and Prices , p. 94.)

A general rise or fall in prices is a disequilibrium process that is “not only permanent, but also cumulative. ⁴

¹ Lectures on Political Economy, Vol.2 , p. 159.

² Ibid ., p. 159.

³ Ibid ., p. 102. Although the level of the natural rate of interest depends upon many factors, it is the prospective rate of return on investment that will have a decisive influence on it.

⁴ Ibid ., p.94. I have to note here, however, that in his original formulation of the cumulative process Wicksell adopted the neoclassical assumption of perfect competition and implicitly supposed that all prices were set by the “market auctioneer, ” à la Leon Walras. In retrospect, Wicksell failed to be thoroughly neoclassical, at least in the way he approached the law of supply and demand. A truly neoclassical economist would not have accepted such a mechanical formulation and would have asked the following question: “Whose behavior is thereby expressed? And how is that behavior motivated? ” (Tjalling Koopmans, Three Essays on the State of Economic Science , New York: McGraw Hill, 1957; p. 179.) Indeed, if the market is assumed to be perfectly competitive in the sense that every buyer and seller regards the price as a parametric signal and makes demand and supply decisions accordingly, as Wicksell assumed without much ado, we have a paradoxical situation in which there is no one left whose job it is to make a decision on price. Indeed, if the price of a commodity moves in response to a disturbance of the equilibrium between demand and supply, such a price movement expresses the imperfectly competitive behavior of producers (or in some cases buyers), which is motivated by their intermittent adjustment of anticipations in light of the observed discrepancies between ex ante and ex post , revealed in the form of excess demand or excess supply in markets. It is for this reason that my Disequilibrium Dynamics dropped the assumption of perfect competition and instead supposed that all products are differentiated from each other and that their price is set by the producer him- or herself. The theory of the cumulative inflation and deflation process I have elucidated in the main text is my reformulation of the Wicksellian theory of cumulative process within a theoretical framework of a monopolistically competitive economy.