Final: The Austrian Theory of the Business Cycle

Question 1

Two Cases for Lower Interest Rates

Answer 1

1) Saving led case (endogenous)
Recall Austrian Capital Theory

2) `Credit expansion case (exogenous)
ABCT

Question 2

Saving-Led Case Explained

Answer 2

1) The saving-led case is not a cycle. It is a viable transition to a new structure of production.

2) Increased saving increases investment
Increased investment raises demand and prices of producers’ goods.
Lower demand and prices of consumers’ goods (people have voluntarily chosen to consume less)

3) Versatile or multi-specific inputs will be attracted to the earlier stages of production

4) New stages have been added, that previously weren’t viable under higher interest rates

5) Longer average period of production

Question 3

The Austrian Theory of the Business Cycle: Boom

Answer 3

1) Central bank increases the money supply

2) Spillover from money market disequilibrium (excess supply) into the LF market

3) Excess supply of money translates to an increase in Slf lower interest rates in the LF market.
New rates lower than the real interest rate.

4) Artificially low interest rates change the capital structure in temporary (and thus undesirable) ways.

5) The result is a short-run monetary policy induced boom.

Question 4

Explain the boom in the Austrian Theory of the business cycle

Answer 4

Lower interest rates drive investment

However, this didn’t occur due to voluntary deferment of consumption. In fact, consumption is still high.

Implication: C + I exceeds total available current resources, and is therefore unsustainable

Credit boom

Question 5

ABCT: Bust

Answer 5

Credit/Real resource crunch brings boom to an end
Real interest rate rises as the scarcity of present Slf becomes apparent

Forced Savings: Fall in consumption due misallocation of resources to early and late stages (but not middle)

Liquidation of malinvestment
Unemployment of capital and labor

Cost of transitioning factors again as the Hayekian triangle shrinks

Possibility of a secondary recession

Question 6

Summary for Boom

Answer 6

Investors get LF at lower interest rates and reallocate capital to the early stages of production

Income-earners save less and attempt to consume more (but only can initially)

Since both consumptive and investment demand increase, the economy is briefly beyond the sustainable “full output” amount
Outside the PPF

Both the early and late stages pull against the middle

Question 7

Summary of Bust

Answer 7

Investors run into real resource scarcity in production, rising wages/prices due to scarcity and M growth.

Increased nominal demand for loanable funds, in conjunction with “distress borrowing” to fund marginal projects drive real rates back up
Some of these projects are unprofitable at higher interest rates, and must be liquidated.

Equipment procured during the boom for use in the early stages might be unsuitable for use in later stages, and thus becomes idle following the bust.
Recession and lower y