The Austrian Business Cycle Theory Part III – Interest, Time & the Unsustainable Boom

1. The Austrian Business Cycle TheoryPart III – Interest, Time &the Unsustainable Boom ECO 285 - Macroeconomics - Dr. Dennis Foster M. Rothbard David Ricardo Ludwig von Mises

2. Why are there Business Cycles? Mises & the Austrians • Central bank precipitates cycle. • Effect is to  interest rates. • Leads to unsustainable increase in Investment. • Eventually, the recession comes to correct for this unsustainable path. Ludwig von Mises F. A. Hayek

3. Capital Structure and the ABCT • Lessons: • To consume, you must produce. • To consume more you must save. • Saving creates resources for investment in capital. • Adding more money doesn’t create more resources. • When the false promise of this money is revealed, investment plans collapse and resources are wasted. The Fed pumps money into the financial sector, not real resources. The resulting boom cannot persist; aka “the hangover theory.”

4. Interest & Time in the ABCT • Interest rates: • Usually referred to as the “time value of money.” • It is a (real) price signal. • It coordinates production across time. • It changes as our time preferences change. • We prefer more goods now; time preference rises;savings falls; interest rates rise. Or… falls less rises fall •  time preference = want more current consumption and less future consumption. •  time preference = want less current consumption and more future consumption.

5. Interest and the Loanable Funds Market S’LF SLF = (real) saving interest S”LF i’ i* i” DLF = investment Loanable funds LF’ LF* LF” If our time preference rises and we want more current consumption, SLF falls and i rises. If our time preference falls and we want more future consumption, SLF rises and i falls.

6. Interest & Coordination in the ABCT • Time preference rises … • We save less. • Interest rates rise. • Investment plans most sensitive will be scrapped. • Consumption goods prices rise. • Resources reallocate from Investment to Consumption. • Disruption depends on how fast preferences change. Interest rates are signaling the market that resources are more highly valued in producing current consumption goods than in producing future consumption goods. Do we want to force interest rates down?

7. Interest & Coordination in the ABCT • Time preference falls … • We save more. • Interest rates fall. • Investment plans most sensitive will be started. • Consumption goods prices fall. • Resources reallocate from Consumption to Investment. • Disruption depends on how fast preferences change. Interest rates are signaling the market that resources are more highly valued in producing future consumption goods than in producing current consumption goods. Do we want to keep interest rates low?

8. The ABCT & the Unsustainable Boom • The Fed MS to i and I (and employment) • But, there has not been a change in time preferences. • The i sends the wrong signal and Investment projects start to compete with Consumption for resources. • Initially may not be noticed; slack resources get used. • Eventually, C and I will have to bid up resource costs. • Inflation dampens I, so Fed further MS. • Effects are only temporary. Fed actions will keep investment plans going even though inflation is pushing up interest rates as well. But, this only gets worse until the Fed halts its actions.

9. The Austrian Business Cycle Theory Some Final Thoughts • There is no market mechanism that causes inflation. • There is no market mechanism that causes business cycles. • The inflation of prices is an effect, not a cause, of economic disruption. The problem of inflation … is not merely a problem of a deteriorating monetary unit. The problem … is that it cuts at the heart of the market process, producing at best intermittent and disruptive cyclical swings and at worst the disastrous cessation of market exchange. Taylor (p. 95)

10. The Austrian Business Cycle TheoryPart III – Interest, Time &the Unsustainable Boom ECO 285 - Macroeconomics - Dr. Dennis Foster Ludwig von Mises