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THE AUSTRIAN THEORY OF BUSINESS CYCLES IN THE CONTEXT OF THE ECONOMIC

CYCLES LITERATURE

Prof. Dr. Miguel A. Alonso NeiraDepartamento de Economía Aplicada I

Universidad Rey Juan Carlos de Madrid

Dr. Miguel A. Alonso

1. Introduction


2. Real business cycles versus monetary cycles

3. The Austrian Theory of endogenous monetary cycle: An approach based on intertemporal structure of capital

Scheme of the seminar:

1. Introduction


One of the eternal debates in Macroeconomic Theory, is if money is short-term neutral or, on the contrary, it creates cyclical movements in production and employment.

Although the great majority of economists accept that the long-term effects of money relapse totally on prices, also many of them admit that the monetary disturbances can have real effects at the short-run.


In a speech delivered in 1995, Robert Lucas pointed out:

“The tension between two incompatible ideas,that the variations in money are neutral at thelong-run and that they induce movements in production and employment in the short-term, has been the center of Monetary Theory at least since Hume's writings”.

Hume (1752) establishes several controversial aspects that will characterize part of the program of academic research of the following centuries.

He assumes that money is long-term neutral, but in the short-run he is nearer to Richard Cantillon's theses.

In other words, in the short run, a monetary expansion not only doesn’t provoke a proportional increase in absolute prices, but also distorts the relative prices structure of the economy, changing the incentives system that guides the decision taking process of the agents.

Therefore, there would be a “transitional period”, in which the real side effects of money, would depend on the form in which money is put into the economy (“Cantillón effect”, 1755). These transitional periods could be lengthy and recurrent, giving place to monetary cycles.


During the last decade, we have observed important studies that have been developed to analyze the assumption of money neutrality, not only in the long-run but also in the shor-run .

Moreover, they show that as bigger is the growth of money supply, the larger is the corresponding increment of production above its natural trend, and vice versa.

Kydland and Prescott (1990) and Walsh (1998), also offer evidence that the variations of the monetary stock preceded the cyclical movements of the short-run production.


Friedman and Schwartz (1963) attribute the Great Depression of the 30s to mistakes of monetary policy.

A summary reading of these works, allows us to conclude that, in general, Hume's prediction of long-run money neutrality, has received a strong support in the academic literature.

However, nothing is said about the evolution of relative prices (which are hidden in absolute prices) that could give place to the so-called “Cantillon Effects”.

On the other hand, the effects of monetary expansions on real activity (specially in the short term), continue creating important debates in modern Economic Theory.

¿Is it money short-run neutral? Depending on how this question is answered, it is possible to find different interpretations on the origins, real or monetary, of cycles.


The necessity of making compatible the apparent long-run neutrality of money with its possible short-term real effects, led to the development of a very active research area: the so-called monetary theories of the business cycles.

In these models, monetary expansions have real side effects (or even in the long-run if we consider the contributions of some Austrian authors) as a consequence of:

Imperfect information problems.

Wages and/or prices rigidities derived from the establishment of long-term contracts, efficiency wages, or menu costs.


2. Real business cycles versus monetary cycles


In general terms, during a boom-bust cycle, it can be observed that:

The volume of production of different sectors is affected with different degrees of intensity.

Inflation and interest rates tend to show a different behavior depending on to the phase of the cycle in which we are.

Sectorial employment moves on the same direction than the level of production of each of the sectors .


Throughout the 20th century, lots of economists tried to give an explanation to economic cycles of variable duration. Any of these theories tries to determine three essential aspects:

What kind of shocks, real or monetary, affect the economy in a more intensive way.

What type of structure is necessary to propagate the perturbances: non-competitive markets, rigidity of prices and/or wages, or incomplete information with regard to prices, real wages or interest rates.


It can be assumed that economic cycles are the result of rational agents' equilibrium reactions in a economic world that works efficiently.


Throughout the 20th century, lots of economists tried to give an explanation to economic cycles of variable duration. Any of these theories tries to determine three essential aspects:

What kind of shocks, real or monetary, affect the economy in a more intensive way.

What type of structure is necessary to propagate the perturbances: non-competitive markets, rigidity of prices and/or wages, or incomplete information with regard to prices, real wages or interest rates.

What kind of factors impinge on the persistence of cycles: duration of wage contracts, processes of accumulation or.deaccumulation of inventories, credit channel, intertemporal ........ dimension of capital...

The analysis of business cycle theories, can be faced by considering the effects of monetary perturbances in all the approaches considered.

This criterion allows us to classify these theories in:


Models of real cycles: that accept the assumption of money neutrality, even in the short-run.

Models of monetary cycle: which assume that money is non- neutral in the short-run (or even in the long-run).

Let's consider briefly the main characteristics of real business cycle models.


Real business cycle models Usually, real business cycle theory (Kydland and Prescott, 1982; Long and Plosser, 1983) is builded under three essential assumptions:

1. It is a general equilibrium model with competitive markets that clear continuously at the corresponding equilibrium prices.

2. It is based on a structure of representative agent who is endowed with rational expectations. This agent maximizes continuously an objective function in a perfect information world.

3. The agents know the structure and the functioning of the economic system in which they must adopt their decisions.


4. Moreover, they are able to anticipate the effects of any fiscal or monetary intervention based on rules.

5. Finally they are able to discriminate between real and monetary shocks.

The combination of these elements allows us to define RBCM as:

Equilibrium structures.

Models in which the assumption of short-term money neutrality is verified.

Real business cycle models Usually, real business cycle theory (Kydland and Prescott, 1982; Long and Plosser, 1983) is builded under three essential assumptions:

Dr. Miguel A. AlonsoDr. Miguel A. AlonsoDr. Miguel A. Alonso

Real business cycle models Nevertheless, it can be verified the existence of models that, by relaxing some of the assumptions of the real business cycle model, refute the short-term money neutrality proposition:

1. Non-competitive markets. Where it is possible to observe the existence of monopolistic or oligopolistic structures.

2. Prices or wages rigidities. Models of “menu costs”, and long-run wage contracts.

3. Problems of imperfect information. In this case, monetary expansions affect the short-term real value of macroeconomic variables, as a consequence of “monetary illusion” or “signal extraction” problems.

3. The Austrian Theory of endogenous monetary cycle: An approach based on

intertemporal structure of capital



An important weakness in the core of contemporary macroeconomic theory, is the absence of a theoretical basis to establish a real connection between the keynesian short- term with:

markets with lots of rigidities and prone to failures, underemployment of productive resources, agents who respond to “animal spirits”

and the neoclassical long-term with:

full flexibility of prices and wages, always efficient markets, and full employment of productive resources


Macroeconomics as a discipline needs of an analytical structure to build a connection between the keynesian short-run world of “perversion” and neoclassical long-term stage of “perfection”.

But we cannot arrive at the long-term without crossing for a sequence of short-runs (Mises, 1949)...

Austrian Macroeconomics arises as an attempt of establishing an analytical framework which allows the possibility of a “perfect” work of markets but, at the same time, identifies possible situations under which markets could fail.


1. The production process is configured by a sequence of stages,which reflects its dynamical and intertemporal character, and the heterogeneity of capital.

2. There exists a natural rate of interest that only depends on realor structural factors of the economy.

• In Austrian Macroeconomics, it is possible to find two characteristics which are not considered in other approaches:


3.1. The origins of the Austrian approach: the monetary theory of

Knut Wicksell


One of the most important contributions of Wicksell is the distinction between the concepts of natural interest rate and monetary (or bank) interest rate.

The natural interest rate does not depend on monetary factors, but it is consistent with the rate of return of firms, the capital structure and the availability of resources (saving) in the economy.

If the natural interest rate prevails in the loan market, there will be an equilibrium between saving and investment, and prices will be constant.

The monetary interest rate is the direct result of banking policy.

If, as a consequence of a credit expansion (not financedby a previous increment of saving), the monetary interestrate places below the natural interest rate, firms willdemand more credits than necessary, and households willhave less incentives to save.


Therefore, a cheap credit policy will throw the economy to a situation of macroeconomic disequilibrium, in which economic growth will ignore the volumen of saving and, at the same time, there will be an increment in prices.

For the Austrians, a (relatively) low monetary interest rate can create a capital allocation which is inconsistent with the natural interest rate and, therefore, with the underlying economic realities:

TechnologyAvailability of resources. Consumption intertemporal preferences.

In the Austrian approach, the misallocation of capital created by an artificially low monetary interest rate, is the basis of a fictitious boom (a bubble) which contains the seeds of its own destruction.


3.2. Garrisonian MacroeconomicsThe Austrian Business Cycle


a) Core principles of Capital Based Macroeconomics


• In a summarized form, Austrian theory shows how a monetary shock can induce an intertemporal miscoordination of economic activities.

• In essence, injections of new money through credit markets, provoke a deviation of monetary interest rates from natural interest rates, creating an intertemporal misallocation of productive resources .

Capital based macroeconomics allows to identify the basic differences between what is considered to be a process of sustainable growth, and a process of artificial or unsustainable growth.

Dr. Miguel A. AlonsoDr. Miguel A. Alonso

Garrison (1986) identifies the key elements of Capital based Macroeconomics, establishing the importance of each one of them:

It is defined as a sequence of stages

The intertemporality of capital is reflected in the hayekian triangle.

Valor final de la producción

Etapas de la producción

Valor final de la producción

Etapas de la producción

The capital structure occupies an intermediate position between inputs (work and natural resources) and the final output, increasing the intertemporal dimension of the production process.

1. Production is a process that requires time.



2. Prices send powerful signals, and interest rates facilitate the coordination of intertemporal decisions.

In a world of imperfect information, prices and interest rates, are a vehicle of information transmission that guides the production and consumption decisions .

If these signals are manipulated by monetary interventions, it will be possible to observe an unsustainable miscoordination between the intertemporal plans of producers and consumers.



On the other hand, free market (natural) interest rates, offer fiable signals of intertemporal preferences of consumption.





3. Money can masquerade as saving.

When monetary authorities increase the quantity of money, they generate a differential between the levels of saving and investment. An artificially low interest rate, creates a miscoordination between the intertemporal plans of decision of the agents.





4. Capital goods are heterogeneous, and reflect certain degrees of intertemporal complementarity. Ricardian effect. Capital goods can be of higher or lower order. The first ones, are used to produce more investment goods, while the second ones are used to produce inmediate consumption goods.

The miscoordinación originated by a monetary expansion, manifests itself through a process of overinvestment in higher order capital goods.






4. Capital goods are heterogeneous, and reflect certain degrees of intertemporal complementarity. Ricardian effect.



In capital theory, variations of interest rates would create a substitution effect between low order and high order capital goods.

Thus, the miscoordinación originated by a monetary expansion manifests itself as a process of overinvestment in higher order capital goods (in detriment of lower order goods).




5. The demand for commodities is not derived from that for work. This is the fourth fundamental proposition of J. S. Mill.




A decrease of consumption does not necessarily imply a reduction of the demand for work (Keynes). Instead, it can imply an increase in the saving level and, therefore, in the future level of consumption.







In a keynesian world the “derived demand” effect prevails over the “time discount” effect, which characterizes the Austrian approach.








6. Agents take decisions in an environment of imperfect knowledge.


7. Businessmen’s expectations are subjective.




Agents take decisions in an environment of imperfect knowledge

Hayek distinguishes two types of knowledge: a) the knowledge of particular circumstances of time and place, and b) the theoretical - scientific knowledge.

Monetary manipulations of prices can induce to market participants, to behave of different forms than in other circunstances or scenaries.

If market members had all the knowledge, artificial manipulations of price information wouldn’t provoke massive mistakes or wrong investments.


It is expected that market participants will have have the first type of knowledge, but not the second one. Therefore, they will not be able to discriminate between real and nominal (monetary) shocks on prices.

Agents take decisions in an environment of imperfect knowledge

Therefore, businessmen do not have complete information of the underlying economic realities.

In this respect, prices, wages and interest rates, encourage the coordination of economic decisions, maintaining them in line with the underlying economic realities.

Collectively, these firm decisions give rise to an intertemporal capital allocation that can be sustainable or unsustainable.

In this respect, capital based Macroeconomics stablishes that one of the main focus of Macroeconomics research, should be the study of the factors that transform a process of economic growth into a sustainable one or a self-destrutive process.

The combination of all these principles, offers a representation of a macroeconomic system in which:

Businessmen take decisions on the basis of their own knowledge and expectations. In their decisions, they are informed and coordinated by prices, wages, and interest rates movements.



b) Graphical characterization of capital based Macroeconomics


Garrison defines three graphical instruments which are the constitutive blocks of his representation of Capital based Macroeoconomics and the Austrian Business Cycle model.

The market of loanable funds

The production possibilities frontier

The hayekian triangle

Etapas de producción

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