What Is Substitutability Theory In Economics?

This theory was developed by Culburtson. According to this theory short term and long term securities are substitutes of one another both from the borrower's point of view and from the lender's point of view. As the prices of substitutes always move in the same direction the short term rates and the long term rates also move in the same direction. As a result of switching operations and arbitrage activities on the part of the lenders and the borrowers the discrepancies between short term rates of interest and long term rates of interest tend to be eliminated. An increase in the prices of the short term securities or a fall in the interest rate on short term securities will tempt the investors to sell away short term securities and purchase long term securities. As a result there will be an excess demand for long term securities and prices of long term securities will also rise implying that long term rates of interest will fall.

However, the substitutability between short term securities and long term securities may not be perfect, particularly in terms of depression. During a period of depression a rise in the prices of short term securities (or a fall in the short rate) by an open market purchase of such securities may not induce the investors to switch over from short term securities to long term securities. Thus though normally the short term and long term securities are substitutes and their prices move in the same direction, there may be special occasions when they cease to be substitutes. In such circumstances the short term rates and the long term rates will not move in the same direction.