Garrison’s Model of Austrian Macroeconomics

1. Garrison’s Model of Austrian Macroeconomics Intermediate Macroeconomics ECON-305 Fall 2013 Professor Dalton Boise State University

2. Distinguishing Beliefs Expectations are forward-looking but each individual agent possesses unique, diverse and partial knowledge-information sets; coordination failures are possible Economy has a tendency towards intertemporal equilibrium output and employment through entrepreneurial adjustments to relative prices

3. Distinguishing Beliefs Cantillon effects assures non-neutrality of money in short and long run Discretionary fiscal and monetary policy increase uncertainty and increase likelihood of coordination problems; rules are preferable to discretion and automatic institutions are preferable to rules.

4. Capital-Based Macroeconomics Based on the Business Cycle Theory of Ludwig von Mises and F. A. Hayek With acknowledgment to Professor Roger W. Garrison, Auburn University

5. “Loanable funds” is the generic term that refers both to lending (which constitutes the supply side of the market) and to borrowing (which constitutes the demand side). Each side of the market for loanable funds is governed by the rate of interest. Saving, broadly conceived, underlies the supply of loanable funds. Consumer borrowing is netted out on the supply side. That is, the focus is on the funds lent collectively by income-earners/savers to the business community. The Market for Loanable Funds The demand for loanable funds represents demand by businesses for investment.

6. Capital-based macro features consumption and investment as alternative ways to use resources. The alternative uses are depicted as a Production Possibilities Frontier (PPF). The PPF shows the maximum sustainable level of output as a locus of points representing all possible combinations of consumption and investment for a fully employed economy. Production Possibilities Frontier

7. Consider a particular point on the frontier. This point represents an economy that is fully employed (with the unemployment rate in the 5%-6% range). Hence, output is being produced at a sustainable rate. Production Possibilities Frontier

8. Now consider a disequilibrium point inside the PPF. This point represents an economy in recession, producing fewer consumption goods and/or fewer investment goods than it could. The distance below the frontier reflects the idleness of labor and other resources. The unemployment rate is higher than 6%, suggesting significant cyclical unemployment. Production Possibilities Frontier

9. Now consider a disequilibrium point beyond the PPF. This point represents an overheated economy. The unemployment rate is below 5%. The level of output is unsustainable. (Points very far beyond the PPF are, of course, literally impossible.) Production Possibilities Frontier

10. Increased saving moves the economy along the PPF in the direction of more investment; decreased saving moves the economy along the PPF in the direction of consumption. Investment in this framework is measured in gross terms. Suppose an investment of $600 billion is needed just to offset depreciation. DEPRECIATION = $600 As long as gross investment is greater than depreciation, the economy will grow, as will be represented by an outward shift in the PPF itself.

11. CONSUMABLE OUTPUT Beyond the two-way division of resource usage captured by the PPF, capital-based macro tracks the intertemporalallocation of investable resources. Production time is measured along the horizontal axis. P R O D U C T I O N T I M E The vertical axis tracks the value dimension—with value at the end of the production process representing consumable output.

12. At a given point in time, an ongoing production process is characterized by activities in all the separate stages. CONSUMABLE OUTPUT STAGES OF PRODUCTION MINING REFINING MANUFACTURING DISTRIBUTIING RETAILING Identifying the stages as “mining” through “retailing” is only suggestive. The actual intertemporal structure of capital, of course, entails a complexity of interconnected production activities.

13. C The resulting figure is known as the Hayekian triangle. First, it depicts the production process that plays itself out over time. Second, it depicts the full complement of stages that exist at a given point in time; the second interpretation suggests that resources can be reallocated in either direction from one stage to another. P R O D U C T I O N T I M E For analytical purposes, the economy’s production process is conceived as a continuum of stages and is represented as goods in the making that gain value as they near completion.

14. The market for loanable-funds—a.k.a. investable resources—shows that the market-clearing rate of interest is 5%, at which saving and investment are in equilibrium at $800 billion.

15. The PPF shows that with $800 billion committed to investment activities, $2200 billion are available for current consumption. The market for loanable-funds—a.k.a. investable resources—shows that the market-clearing rate of interest is 5%, at which saving and investment are in equilibrium at $800 billion.

16. The Hayekian triangle depicts current consumption as the output of the economy’s multi-stage production process. The rate of interest governs the allocation of resources among the stages.

17. The slope of the hypotenuse of the Hayekian triangle reflects a rate of interest consistent with the rate that prevails in the loanable- funds market.

18. An initial full-employment equilibrium is defined by: the Loanable-Funds Market, the PPF, the Hayekian Triangle,...

19. …plus the representative stage-specific labor markets.

20. $600 If gross investment needed to offset capital depreciation is $600 billion, the economy is experiencing net investment of $200 billion.

21. $600 The increase in productive capacity and hence in output is depicted by a shifting outward of the PPF and by a corresponding shifting of the supply and demand for loanable funds.

22. $600 This additional capital is distributed among the stages of production in accordance with an unchanged rate of interest.

23. Watch the economy grow!

24. The supply of loanable funds registers people’s current saving preferences. Changes in saving behavior for the economy as a whole can stem from a change in demographics or from a change in attitudes toward saving. Suppose that, for whatever reason, people decide to save more. The loanable funds market strikes a new equilibrium. Both saving and investment increase to $1,000 billion.

25. The PPF shows how the increased saving affects the mix of consumption and investment. For a given income, saving more means consuming less. The economy moves along the frontier, as current consumption is reduced from $2,200 billion to $1,780 billion. Resources are shifted away from production activities aimed at the present and near-future and toward production activities aimed at the more remote future.

26. A reshaping of the Hayekian triangle mirrors the move-ment along the PPF in the direction of investment and depicts the change in the time dimension in the production process.

27. With reduced consumption demand, the derived demand for labor and other factors of production in the late stages is reduced as well.

28. In the early stages, demand for labor and other factors of production is increased, as the interest-rate effect more-than-offsets the derived-demand effect .

29. A wage-rate differential during the capital restructuring encourages workers to move from late stages to early stages.

30. A wage-rate differential during the capital restructuring encourages workers to move from late stages to early stages.

31. Watch the economy respond to an increase in saving.

32. Watch the economy respond to an increase in saving.

33. A saving-induced reallocation of resources among the stages of production skews the pattern of consumable output toward the future.

34. Early-stage investments during this transition allow the increased future demands for consumption goods to be accommodated. The economy grows more rapidly than before.

35. People don’t just save; they save-up-for-something. Consumption is down only temporarily—during the transition to new growth path.

36. Now watch the economy grow!

37. Now watch the economy grow!

38. Now watch the economy grow!

39. Accelerated growth driven by an increase in saving entails a market process in which the interest rate falls and investment increases. Policymakers may misunderstand the nature of the process and believe that low interest rates (rather than increased saving) is the cause of the increased growth rate. With this understanding in mind, Congress might enact an interest-rate ceiling, prohibiting a yield of more than, say, 2.3% on financial assets.

40. Accelerated growth driven by an increase in saving entails a market process in which the interest rate falls and investment increases. Policymakers may misunderstand the nature of the process and believe that low interest rates (rather than increased saving) is the cause of the increased growth rate. With this understanding in mind, Congress might enact an interest-rate ceiling, prohibiting a yield of more than, say, 2.3% on financial assets. The result would be a credit shortage, which would be apparent as soon as the legislation went into effect.

41. Accelerated growth driven by an increase in saving entails a market process in which the interest rate falls and investment increases. Policymakers may misunderstand the nature of the process and believe that low interest rates (rather than increased saving) is the cause of the increased growth rate. With this understanding in mind, Congress might enact an interest-rate ceiling, prohibiting a yield of more than, say, 2.3% on financial assets. The result would be a credit shortage, which would be apparent as soon as the legislation went into effect.

42. Accelerated growth driven by an increase in saving entails a market process in which the interest rate falls and investment increases. Policymakers may misunderstand the nature of the process and believe that low interest rates (rather than increased saving) is the cause of the increased growth rate. With this understanding in mind, Congress might enact an interest-rate ceiling, prohibiting a yield of more than, say, 2.3% on financial assets. With the yield on financial assets held to 2.3%, the yield on real assets would rise to 7.7%, as indicated by the demand price.

43. Accelerated growth driven by an increase in saving entails a market process in which the interest rate falls and investment increases. Policymakers may misunderstand the nature of the process and believe that low interest rates (rather than increased saving) is the cause of the increased growth rate. With this understanding in mind, Congress might enact an interest-rate ceiling, prohibiting a yield of more than, say, 2.3% on financial assets. With the yield on financial assets held to 2.3%, the yield on real assets would rise to 7.7%, as indicated by the demand price.

44. In the face of diminished incentives to save, people begin consuming more. Foiled by the interest-rate ceiling, people increase their consumption to $2,480 billion, moving the economy counterclockwise along the PPF.

45. In the face of diminished incentives to save, people begin consuming more. Foiled by the interest-rate ceiling, people increase their consumption to $2,480 billion, moving the economy counterclockwise along the PPF.

46. There is now a premium on producing for the present. Labor and other resources are bid away from early stages of production and into late stages. The value added at each stage reflects the yield on real assets of 7.7%.

47. There is now a premium on producing for the present. Labor and other resources are bid away from early stages of production and into late stages. The value added at each stage reflects the yield on real assets of 7.7%.

48. The market-clearing wage rate for late-stage labor will be higher than the market-clearing wage rate for early-stage labor during the period that the intertemporal capital structure is adjusting to the credit ceiling.