Monday, March 06, 2006


Austrian Business Cycle Theory

Most of the ideas in this post can be found in "Inflation, Recession, and Stagflation" by O'Driscoll and Shenoy, 1976.

Things you need to know for the Austrian perspective to make sense:

1) Changes in the money supply affect real interest rates
2) Interest rates are prices that coordinate plans
3) Without (unexpected) changes in the money supply, interest rates reflect true time preferences
4) Capital goods are not perfectly homogeneous and substitutable
5) Changes in the money supply affect relative prices
6) Inflation refers to increases in the money supply (prices rising is a consequence)

To illustrate Austrian Business Cycle Theory, I need an example: What are the consequences of increasing the money supply (inflation)?

An (unexpected) increase in the money supply lowers interest rates. Those lower interest rates send a signal to producers to engage in production that is farther removed from final consumption, although true time preferences are unchanged (has the same effect as a true increase in the supply of loanable funds, i.e., an increase in savings). It follows from (2) and (3) that any artificial change in interest rates causes discoordination: producers are expecting future demand to be higher because the distorted price signal has told them that people are putting off present consumption in favor of future consumption.

Since (4), producers are incurring the cost of shifting capital to farther-removed stages of production in anticipation of a future payoff in the form of higher demand. Demand does increase for factors of production used in farther-removed stages, since they are made more attractive by the lower interest rates. Meanwhile, demand falls for factors used in stages nearer consumption. This may have the net effect of decreasing overall unemployment or looking like a "Boom."

Despite all this preparation, the higher consumption demand never comes. There is no reason to believe it ever should come, since the change in interest rates did not reflect true time preferences [note: by (5), demand for some consumption goods could increase where the new money is injected, but not in general]. Recession and unemployment show up with the inevitable bust.

Any further inflation will only deepen this spiral and create more discoordination. Sadly, this is the cause of stagflation, where we have both high inflation and high unemployment. The best way out of stagflation is to put an end to the discoordination (inflation), but this is politically unpopular because it causes higher short-term unemployment than just continuing to inflate the money supply.

If inflation is never confronted and continues to accelerate, the result is the complete failure of the currency as it becomes useless or too cumbersome to carry (think of the hyperinflation in Germany after WW I).

P.S. Here's an interesting quote from Rudolf Havenstein, the president of the Reichsbank in 1923:
The wholly extraordinary depreciation of the mark has naturally created a rapidly increasing demand for additional currency, which the Reichsbank has not always been able fully to satisfy. A simplified production of notes of large denominations enabled us to bring ever greater amounts into circulation. But these enormous sums are barely adequate to cover the vastly increased demand for the means of payment, which has just recently attained an absolutely fantastic level....The running of the Reichsbank's note-printing organization, which has become absolutely enormous, is making the most extreme demands on our personnel.
I read it in Murray Rothbard's "Austrian Theory of Money."

Good exposition, Travis.

My two questions concerning ABCT are:

1) Why do we assume entreprenuers are so stupid when it comes to recognizing that interest rates are artifically low? Especially in with monetary policy so transparent today compared with years past?

2) Why does the boom end with recession? Even a Keynesian evaluation of an unexpected increase in money supply growth (at full employment) might lead to an unsustainable boom (production beyond full employment). But it will instead predict a return to full employment. Why should output fall bellow its previous full employment level?

Bryan Caplan makes a strong criticism i thought was pretty original.

3) ABCT might not explain business cycles at all. "If, as in the Austrian theory, initial consumption/investment preferences "re-assert themselves," why don't the consumption goods industries enjoy a huge boom during depressions? After all, if the prices of the capital goods factors are too high, are not the prices of the consumption goods factors too low? Wage workers in capital goods industries are unhappy when old time preferences re-assert themselves. But wage workers in consumer goods industries should be overjoyed. The Austrian theory predicts a decline in employment in some sectors, but an increase in others; thus, it does nothing to explain why unemployment is high during the "bust" and low during the "boom." "
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Just a comment on the readability.
I think you need to bring all of the economic relationships together a bit more. Perhaps spell it all out at times, so it flows a little better.

One comment on the reading (and Dallas' comment) -- it would seem that under these simplified conditions, we can assume most of the entrepreneurs will trust the 'price signal' that they view in the economy rather than suspect "foul play" by a Central Bank, causing this discoordination.

Generally it seems that the Austrians don't like to do that sort of thing, but then again it is a theory (simplified reality).

More comments to come -- got some reading to do first.
I don't know, Chris--Dallas said it was a "good exposition."

If it were any longer you might as well read the O'Driscoll and Shenoy paper.

But I do want it to make sense, so what in particular is unclear?
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