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One student at LSE in the 1930s recalls the "three-dimensional diagrams with which Hayek presented his ideas and which made them seem like something in the field of engineering.".

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F. A. HAYEK

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One student at LSE in the 1930s recalls the "three-dimensional diagrams with which Hayek presented his ideas and which made them seem like something in the field of engineering."

Another LSE student noted that Hayek wore "a thick tweed suit with a waistcoat and high-cut jacket." She nicknamed him 'Mr. Fluctooations' as he so often used that word and pronounced it in that way.“

-from Alan Ebenstein’s Friedrich A. Hayek: A Biography

F. A. HAYEK


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Sustainable and Unsustainable Growth

An Application of Capital-Based Macroeconomics

Based on the Theory of the Business Cycle set out by Ludwig von Mises and F. A. Hayek


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Go To the original version of this show, which was created in 1999.

Time and Money

Table of Contents

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Part I: The Elements of Capital-Based Macroeconomics

Part II: Integrating the Elements

Part III: Saving as a Basis for Sustainable Growth

Part IV: Legislating Low Interest Rates

Part V: Manipulating Interest Rates with Money

Part VI. Letting the Economy Grow


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PART I

Go To:Table of Contents

The Elements of Capital-Based Macroeconomics


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“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.

The Market for Loanable Funds


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“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.

Borrowing by the business community constitutes the demand.

The Market for Loanable Funds


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“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.

Borrowing by the business community constitutes the demand.

As recognized by both Eugen von Bohm-Bawerk and John Maynard Keynes, this market is better thought of as the market for investable resources. It keeps the macroeconomically relevant magnitudes of saving (S) and investment (I) in balance.

The quantity axis measures saving (and investment) as the amount of output produced in a given period and made available for (and actually used for) the expansion of the economy’s productive capacity.

The Market for Loanable Funds


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The supply price of investable resources is measured by (and sometimes proxied by) the rate of interest. Though saving can actually take the form of lending through banking institutions, it can also take the form of retained earnings or the buying of bonds or equity shares.

The demand price is similarly interpreted to include the various ways that the business community can take command of unconsumed output—which constitutes the investable resources.

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.

In this graphical exposition, the supply and demand for investable funds results in a market-clearing interest rate of 5% with saving and investment amounting to $800 billion.

The Market for Loanable Funds


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The supply price of investable resources is measured by (and sometimes proxied by) the rate of interest. Though saving can actually take the form of lending through banking institutions, it can also take the form of retained earnings or the buying of bonds or equity shares.

The demand price is similarly interpreted to include the various ways that the business community can take command of unconsumed output—which constitutes the investable resources.

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.

In this graphical exposition, the supply and demand for investable funds results in a market-clearing interest rate of 5% with saving and investment amounting to $800 billion.

The Market for Loanable Funds


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Capital-based macro features consumption and investment as alternative ways to use resources.

The alternative uses are depicted as a Production Possibilities Frontier (PPF).


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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


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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


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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.

Now consider a disequilibrium point inside the PPF.

Production Possibilities Frontier

The distance below the frontier reflects the idleness of labor and other resources. The unemployment rate is higher than 6%, suggesting significant cyclical unemployment.

This point represents an economy in recession, producing fewer consumption goods and/or fewer investment goods than it could.


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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


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The second P in PPF suggests that it is actually possible for the economy to move along the frontier—a possibility denied by Keynes with his paradox of thrift.

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.

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.

Investment in this framework is measured in gross terms. Suppose an investment of $600 billion is needed just to offset depreciation.


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CONSUMABLE OUTPUT

The vertical axis tracks the value dimension—with value at the end of the production process representing consumable output.

Hayek conceived of a number of distinct stages of production, the output of each feeding into the next as input.

P R O D U C T I O N T I M E

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.

Each stage, then, has its own time dimension and value dimension. A stage’s value dimension reflects the discounted value of the future consumable output.


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At a given point in time, an ongoing production process is characterized by activities in all the separate stages.

CONSUMABLE OUTPUT

Dividing the economy’s Production process into five stages is a matter of pedagogical convenience.

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.


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The resulting figure is known as the Hayekian triangle.

Strictly speaking, the triangle constrains the production process to a particular type: continuous-input/point-output. The “value added” at each stage consists of two components:

(1) the adding of further inputs and

(2) the movement in time towards the ultimate yield of consumable output.

CONSUMABLE OUTPUT

S T A G E S O F P R O D U C T I O N

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.


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C

The Hayekian Triangle, then, has two mutually reinforcing interpretations.

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.

This second interpretation suggests that resources can be reallocated in either direction from one stage to another.

Reallocation among the stages will affect the temporal pattern of consumable output

P R O D U C T I O N T I M E

While at each point in time there are goods in the making at each stage, the economy’s ultimate output can be identified with a temporal sequence of activities.

Watch the goods in progress move through the stages.


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PART II

Go To:Table of Contents

Integrating the Elements


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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.


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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.


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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.


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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.

An initial full-employment equilibrium is defined by:

the Loanable-Funds Market,

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.

the PPF,

the Hayekian Triangle,...


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…plus the representative stage-specific labor markets.


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$600

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


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$600

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

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.


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Watch the economy grow!


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Watch the economy grow!


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Watch the economy grow!


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Watch the economy grow!


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With gross investment greater than capital depreciation, the economy experiences secular growth. This rate of growth is sustainable.

To the extent that increased incomes and wealth reduce the premium on current consumption and increase saving propensities, the economy will grow faster.

We turn next to the effect of increased saving, whatever the underlying cause of the increase.


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PART III

Go To:Table of Contents

Saving as a Basis for Sustainable Economic Growth


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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. People may become more conscious of the need to save for their children’s education or for their retirement years.

Suppose that, for whatever reason, people decide to save more.


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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. People may become more conscious of the need to save for their children’s education or for their retirement years.

Suppose that, for whatever reason, people decide to save more.

The supply of loanable funds shifts to the right, registering the increased inclination to save, or equivalently, the decrease in time preferences.

The interest rate falls from 5% to 2.3%, encouraging the business community to increase investment from $800 billion to $1000 billion.


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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. People may become more conscious of the need to save for their children’s education or for their retirement years.

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.


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The PPF shows how the increased saving affects the mix of consumption and investment.

For a given income, saving more means consuming less.


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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.


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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.


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

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 .


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


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


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Watch the economy respond to an increase in saving.


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Watch the economy respond to an increase in saving.


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

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

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

Now watch the economy grow!


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Now watch the economy grow!


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Now watch the economy grow!


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Now watch the economy grow!


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Saving & Growth

An initial increase in saving, attributable to a change in intertemporal consumption preferences, is depicted by a movement along the PPF.

The increase investment made possible by this initial saving allows PPF to shift outward in larger increments than before the change in intertemporal preferences.


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PART IV

Go To:Table of Contents

Legislating Low Interest Rates


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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.


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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.


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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.


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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.


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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.


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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.


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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.


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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.


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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%.


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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%.


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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.


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Now, watch the economy react to a credit ceiling.


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Now, watch the economy react to a credit ceiling.


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PART V

Go To:Table of Contents

Manipulating Interest Rates with Money


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A lower interest rate imposed on the market by direct legislation has a negative effect—and one that becomes apparent almost immediately.

A seemingly positive effect—though only a temporary one—can be achieved if the interest rate is lowered not by an act of Congress but rather by an act of the central bank.


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A lower interest rate imposed on the market by direct legislation has a negative effect—and one that becomes apparent almost immediately.

A seemingly positive effect—though only a temporary one—can be achieved if the interest rate is lowered not by an act of Congress but rather by an act of the central bank.


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A lower interest rate imposed on the market by direct legislation has a negative effect—and one that becomes apparent almost immediately.

A seemingly positive effect—though only a temporary one—can be achieved if the interest rate is lowered not by an act of Congress but rather by an act of the central bank.


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The Federal Reserve can increase the money supply by lending into existence an additional quantity of money.

Injecting money so as to drive the interest rate down to 2.3% is equivalent—at least in its initial effects—to imposing an interest-rate ceiling of 2.3% and then “papering over the credit shortage” with newly created money.


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Padding the supply of loanable funds with new money drives a wedge between saving and investment.

The easy-money policy obscures the resulting reduction in saving while it spurs on investment activities with a ready supply of credit at a low rate of interest.

Whereas the problems of an interest-rate ceiling are immediately apparent, the problems of a credit expansion are pushed into the future—and are allowed to fester until they eventually do become apparent.


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The conflicting market forces pit consumers against investors in a tug-of-war.


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The conflicting market forces pit consumers against investors in a tug-of-war.

With less saving and more spending, the behavior of consumers is consistent with a counterclockwise movement along the PPF. But with production decisions governed by a low interest rate, the behavior of investors is consistent with a clockwise movement along the PPF.


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The conflicting market forces pit consumers against investors in a tug-of-war.

Together, consumers and investors push the economy beyond its PPF.

The policy-induced combination of consumption and investment is unsustainable….


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The conflicting market forces pit consumers against investors in a tug-of-war.

Together, consumers and investors push the economy beyond its PPF.

The policy-induced combination of consumption and investment is unsustainable….

…but politically popular.


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The conflicting market forces pit consumers against investors in a tug-of-war.

Together, consumers and investors push the economy beyond its PPF.

The policy-induced combination of consumption and investment is unsustainable….

…but politically popular.


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Excessively long-term projects are initiated at the same time that consumer demand is unusually high.

The “wedge” and “tug-of-war” translate into a distortion of the structure of production.


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Excessively long-term projects are initiated at the same time that consumer demand is unusually high.

The “wedge” and “tug-of-war” translate into a distortion of the structure of production.


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The Hayekian triangle is being pulled at both ends against the middle. The market process it set against itself as investors and consumers respond in their own way to a low rate of interest.

The resources committed to the early stages of production constitute “malinvestment.”

At the same time, other resources are allocated to the late stages in response to the “overconsumption.”


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The specific course of the boom-bust cycle beyond the initial malinvestment and overconsumption is not wholly determinate. The demand for loanable funds can be affected by distress borrowing and/or a loss of business confidence.

The supply of loanable funds can be affected by increased liquidity preference and the consequent building up of monetary hoards and by the actions of the Federal Reserve aimed at mitigating the downturn.

For a time, increased consumption and increased investment have their separate effects. The economy moves beyond the PPF, producing an unsustainable level of output.

Further, changes in the structure of production reflect capital durability and specificity and the particular pattern of complementarities and substitutabilities.


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There is an investment bias in the allocation of resources, however—as the business community tries to take advantage of the artificially low rate of interest and at the same time satisfy increased consumer demand.

The tug-of-war between consumption and investment is partially won by the investment, if only because it has more “pull”—the new money being lent predominantly to businesses.

The lacking of capital and other resources complementary to those already committed to the production process eventually brings the boom to an end and returns the economy to its PPF.


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The initial movement of the economy beyond the PPF constitutes overconsumption (the upward movement) and overinvestment (the rightward movement).

The subsequent reduction in consumption made necessary by the overcommitment of resources to long-term investment projects constitutes “forced saving.”


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The discoordination of the economy characteristic of a policy-induced boom-bust cycle sets the stage for a secondary contraction—a spiraling of the economy to some point inside the PPF.

In this phase of the cycle, a collapse of the money supply can give leverage to the contraction, making the depression much deeper than can be accounted for solely in terms of the prior misallocation of resources.


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Watch the economy respond to an injection of money through credit markets!


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Watch the economy respond to an injection of money through credit markets!


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PART VI

Go To:Table of Contents

Letting the Economy Grow


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Don’t grow the economy.

Just let the economy grow.


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Don’t grow the economy.

Just let the economy grow.


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Don’t grow the economy.

Just let the economy grow.


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Don’t grow the economy.

Just let the economy grow.


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Don’t grow the economy.

Just let the economy grow.


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Don’t grow the economy.

Just let the economy grow.


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Go To:Table of Contents

E-mail R. W. Garrison


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“Booms have always appeared with a great increase in investment, a large part of which proved to be erroneous, mistaken. That, of course, suggests that a supply of capital was made apparent which wasn’t actually existing. The whole combination of a stimulus to invest on a large scale followed by a period of acute scarcity of capital is consistent with the idea that there has been a misdirection due to monetary influences.

And that general schema, I still believe (circa 1978), is correct.”

-paraphrased from an interview conducted by Jack High as part of the UCLA Oral History Program (1978).

F. A. HAYEK


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Time and Money: The Macroeconomics of Capital Structure London: Routledge, 2001.

Time and Money develops and defends this capital-based macroeconomic framework and compares it to the alternative frameworks associated with Keynesianism and Monetarism.

Going beyond the issues of growth and cyclical variation, the book also deals with deficit spending, credit controls, tax reform, and more.

Excerpts from the book plus some supplementary material can be found at http://www. auburn.edu/~garriro

F. A. HAYEK


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