Question

Briefly explain the Austrian Business Cycle. Use diagrams to support your statements.

Answer 1

The Austrian theory of the business cycle

As summarized by Machlup (1976: 23), “monetary factors cause the cycle but real
phenomena constitute it”. The monetary explanation of the business cycle is the first main
feature of the Austrian theory: ”the artificial boom had been brought on by the extension of
credit and by lowering of the rate of interest consequent on the intervention of the banks.
The crisis and the ensuing period of depression are the culmination of the period of unjustified
investment brought about by the extension of credit” (Mises 1912: 28). In other words, a non-
monetary economy would achieve the general equilibrium characterized by the equality
between the natural rate and the market rate: the market rate is the natural rate which equates
flows of planned saving and investment.

From then on, the upward movement is caused by an excess supply of money which depresses
the market rate below the natural rate. During this period of policy-induced credit expansion,
the injection of additional money by banks drives a wedge between saving and investment.
”Projects which would not have been thought profitable if the rate of interest had not been
influenced by the manipulations of the banks, and which, therefore, would not have been
undertaken, are nevertheless found profitable and can be initiated” (Mises, 1912: 26). There is
paradoxically both more investment and less saving because with the lower interest rate,
consumers save less and consume more.
As the Austrian concept is not homogeneous, the change in the market interest rate causes
different shifts in demand by capital type. A same lowering of interest rate implies a greater
rise of demand for capital used in more capitalistic processes than in less capitalistic
processes. This difference leads to emphasize a second feature of the Austrian theory: changes
in aggregate economic activity are considered through changes in structure of production. A
distinctive Austrian hypothesis is that when the market rate is depressed below the natural
rate, investment in process with longer time periods until the final product is available increases relative to investment in closer process in time to final consumption. In Hayek’s
terms, the production process becomes more roundabout.
But this change is unsustainable because the depressed interest rate does not result from
agents’ lowered time preference, that is from a rise of households’ saving, but from policy-
induced reduction. In contrast, preference induced reductions in the interest rate
simultaneously lower consumption spending and increase households’ saving. In the absence
of the credit injection introduced by expansionary monetary policy, the only funds which can
be borrowed to finance investment spending are household savings. So a change in agents’
time preference corresponds to an appropriate change in the production process
roundaboutness. When the central bank injects credit, investment spending exceeds the
amount saved by households. The below-equilibrium interest rate results in an economy
which takes longer to produce consumable output but also ensures consumers are less willing
to wait for satisfying their wants. This production structure is unsustainable and its general
collapse becomes inevitable as entrepreneurs start to realize their plans can not be completed
and must be modified or abandoned. So the expansion phase of the cycle creates the condition
for the recession phase: the endogenous reversal of the expansion leading to recession is the
third feature of the Austrian theory.
Excess demand for consumer goods will increase their price so that resources allocations are
reversed: investments in later-stage of production are preferred to investments in early-stage
of production. This reallocation of capital increases demand for credit. In order to attempt to
avoid the collapse, monetary authorities can increase the money supply, even faster. But their
reserve are limited so that demand for credit finally outstrips the banks’ oversupply, driving
interest rates up, leading to massive abandonment of production plans. Market forces cause
interest rate to move toward the level consistent with time preferences and the balance
between investment and saving.

The Austrian business cycle theory can be summarized by the following sequence:
1- A monetary shock causes the market interest rate to decrease relative to the natural interest rate.
2- While the interest rate is artificially depressed during the expansion phase, firms invest intensively in physical capital. Investment in early-stage rises faster than investment in later-stage, implying a rise in production goods prices relative to final goods prices.
3- The relative shortage of consumption goods created by more roundabout production processes increases their relative prices, reflecting new opportunities of
profit which pave the way for new reallocation of capital stock.
4- As the price level for final goods rises through the expansion phase, the real supply of credit decreases and the market rate rises.
5- The return to less roundabout production process becomes inevitable: the crisis corresponds to the overinvestment liquidation.

This chronology emphasizes the essential role of price signals. Cycles develop response to
distortions between final goods prices relative to production goods prices. These changes in
relative prices permit cycles not only to develop but also to reduce: there is no requirement of
an exogenous shock to convert expansion to recession.