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low the banker raises the rate of interest to « protect » those reserves. If the reserves are abundant, he reduces the rate of interest in order to get rid of them. But he mistakes a merely relative scarcity or abundance of reserves (as compared with money in circulation) for an absolute scarcity or abundance. When he says that more money lowers the rate of interest, he ought to say « When bank reserves get an undue fraction of money, the rate of interest will be low; but when an undue fraction goes into circulation outside of banks, the rate of interest will be high ». In other words, an increase of money will operate in two different ways, according to where it happens to go first. Normally, however, and eventually an increase of money distributes itself equally among pockets, tills, and bank reserves; and, in this case the rate of interest will not be affected at all.
We conclude, then, that an inflation of the currency, as such, does not affect the rate of interest at all, provided, however, the inflation affects the loan at the time the loan is made just as much as it affects the repayment at the time the repayment is made. This proviso is important. For the loan and the repayment do not occur at the same time; and it may be that the degree of inflation is greater or less at the end than at the beginning of the intervening period, in which case the inflation may, through its effects on the values borrowed and repaid, affect the rate of interest during the process of change.
Let us consider this transitional effect. Suppose, for instance, that the inflation of money has proceeded at such a pace that prices have been made to rise at the rate of one per cent per annum. Then 100 dollars lent last year is equivalent in purchasing power not to 100 dollars repayable next year, but to 101 repayable next year. If prices had not risen, the borrower would pay back in his principal of 100 the value of the same amount of goods as were represented by the 100 which he borrowed. In terms of goods be would be in the same position at the end as at the beginning, and so would the lender. But we are supposing that prices have been rising. Then the lender, when he gets back his principal of 100, does not get back as much purchasing power as he lent, and the borrower does not pay back as much purchasing power as he borrowed. Under these circumstances, the principal of a debt