The Austrian Business Cycle Theory

Part III – Interest, Time &Part III – Interest, Time &the Unsustainable Boomthe Unsustainable Boom

ECO 285 - Macroeconomics - Dr. Dennis Foster

David RicardoDavid Ricardo

Ludwig von MisesLudwig von Mises

M. RothbardM. Rothbard

Why are there Business Cycles?

Mises & the AustriansMises & the Austrians

•Central bank precipitates cycle.Central bank precipitates cycle.•Effect is to Effect is to interest rates. interest rates.•Leads to unsustainable increase in Leads to unsustainable increase in Investment.Investment.•Eventually, the recession comes to correct Eventually, the recession comes to correct for this unsustainable path.for this unsustainable path.

F. A. HayekF. A. Hayek

Ludwig von MisesLudwig von Mises

• Lessons:Lessons:

1.1. To consume, you must produce.To consume, you must produce.

2.2. To consume more you must save.To consume more you must save.

3.3. Saving creates resources for investment in capital.Saving creates resources for investment in capital.

4.4. Adding more money doesn’t create more resources.Adding more money doesn’t create more resources.

5.5. When the false promise of this money is revealed, When the false promise of this money is revealed, investment plans collapse and resources are wasted.investment plans collapse and resources are wasted.

The Fed pumps money into the financial sector, not real resources. The resulting boom cannot persist; aka “the hangover theory.”

Capital Structure and the ABCT

• Interest rates:Interest rates: Usually referred to as the “time value of money.”Usually referred to as the “time value of money.”

It is a (real) price signal.It is a (real) price signal.

It coordinates production across time.It coordinates production across time.

It changes as our time preferences change.It changes as our time preferences change.

• We prefer more goods now; time preference rises;We prefer more goods now; time preference rises;savings falls; interest rates rise. Or…savings falls; interest rates rise. Or…

time preference = want more current consumption and less future consumption.

time preference = want less current consumption and more future consumption.

Interest & Time in the ABCT

fallfalllessless fallsfalls

riserisess

If our time preference rises and we want more current consumption, SLF falls and i rises.

Interest and the Loanable Funds Market

i*i*

SSLFLF = (real) = (real) savingsaving

DDLFLF = = investmentinvestment

interesinterestt

Loanable Loanable fundsfunds

LF*LF*

S’S’LFLF

i’i’

LF’LF’

If our time preference falls and we want more future consumption, SLF rises and i falls.

S”S”LL

FF

i”i”

LF”LF”

Interest & Coordination in the ABCT

•Time preference rises … We save less.

Interest rates rise.

Investment plans most sensitive will be scrapped.

Consumption goods prices rise.

Resources reallocate from Investment to Consumption.

Disruption depends on how fast preferences change.

Interest rates are signaling the market that resources are more highly valued in producing current consumption goods than in producing future consumption goods.

Do we want to force interest rates down?

Interest & Coordination in the ABCT

Interest rates are signaling the market that resources are more highly valued in producing future consumption goods than in producing current consumption goods.

Do we want to keep interest rates low?

•Time preference falls … We save more.

Interest rates fall.

Investment plans most sensitive will be started.

Consumption goods prices fall.

Resources reallocate from Consumption to Investment.

Disruption depends on how fast preferences change.

• The Fed The Fed MS to MS to i and i and I (and employment)I (and employment)• But, there has not been a change in time preferences.But, there has not been a change in time preferences.• The The i sends the wrong signal and Investment projects i sends the wrong signal and Investment projects

start to compete with Consumption for resources.start to compete with Consumption for resources.• Initially may not be noticed; slack resources get used.Initially may not be noticed; slack resources get used.• Eventually, C and I will have to bid up resource costs.Eventually, C and I will have to bid up resource costs.• Inflation dampens I, so Fed further Inflation dampens I, so Fed further MS.MS.• Effects are only temporary.Effects are only temporary.

Fed actions will keep investment plans going even though inflation is pushing up interest rates as well. But, this only gets worse until the Fed halts its actions.

The ABCT & the Unsustainable Boom

Some Final ThoughtsSome Final Thoughts

•There is no market mechanism that causes inflation.There is no market mechanism that causes inflation.•There is no market mechanism that causes business cycles.There is no market mechanism that causes business cycles.•The inflation of prices is an effect, not a cause, of economic The inflation of prices is an effect, not a cause, of economic disruption.disruption.

The problem of inflation … is not merely a problem of a deteriorating monetary unit. The problem … is that it cuts at the heart of the market process, producing at best intermittent and disruptive cyclical swings and at worst the disastrous cessation of market exchange.

Taylor (p. 95)

The Austrian Business Cycle Theory

The Austrian Business Cycle TheoryPart III – Interest, Time &Part III – Interest, Time &the Unsustainable Boomthe Unsustainable Boom

ECO 285 - Macroeconomics - Dr. Dennis Foster

Ludwig von MisesLudwig von Mises