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Austrian Theory of the Trade Cycle II (lecture 16 of 32)

June 21, 2004

These notes are from the lecture Austrian Theory of the Trade Cycle II, given at the Mises University. Any errors are mine, feel free to point them out so that I can correct them. This lecture was given by Prof. Murphy. *Note: I will eventually put pictures in some of these notes, including this one.


Garrison's Interlocking Graphical Framework
  • In Garrison's interlocking graphical framework, we have Hayek triangle lining up with a PPF and a demand and supply graph for loans.

 

  • Hayek Triangle (HT):
    • On the x-axis, we have time, representing the various stages of production.
      • Higher orders of production are earlier in time.
      • Lower orders of production are later in time.
      • As goods move down the production pipeline, approaching their final state, they become more expensive.
    • On the y-axis, we have the market value of the goods. At the far right end of the y-axis, the market value of the goods is equivalent to the amount of money spent on consumption, which lines up with the [Consumption,Investment] coordinates on the Production Possibilities Frontier (PPF).
    • The slope of the Hayek triangle should be equivalent to the prevaling market interest rate.

 

  • Production Possiblities Frontier (PPF):
    • On the y-axis, we have dollars spent on consumption. The particular y-coordinate designated aligns with the market value of the goods in the Hayek triangle when they are consumed.
    • On the x-axis, we have dollars spents on investment. The particular x-coordinate designated aligns with the quantity of loans (loanable funds) provided at equilibrium in the supply and demand graph for loans.
    • This graph represents the tradeoff to be made between Investment (I) and Consumption (C).
    • Any given dollar can either be spent on consumption or investment; thus, on net, dollars spent on consumption subract from those spent on investment.

 

  • Supply and Demand for Loans:
    • On the y-axis, we have the Interest Rate (i) of the loans provided.
      • The interest rate at the "point" where supply and demand intersect is equivalent to the slope of the Hayek triangle.
      • *note: supply and demand curves do not actually "intersect", meeting at an exact point; this is merely a graphical convenience; real economic phenomena are not continuous, but are discrete).
    • On the x-axis, we have the Quantity of loans supplied (Q). The quantity of loans supplied at the "intersection" of supply and demand is equal to the amount of investment at the designated point on the Production Possibilities Frontier (PPF).
    • The supply curve of loanable funds is influneced by consumers.
    • The demand for loans is influenced by businessmen.


When There is a Real Decrease in Time-Preference, Economic Growth Occurs

  1. Time-preferences become lower.
  2. Interest rates to become lower, as individuals no-longer require as high a return on their money to give up a certain amount of money in the present.
  3. Investment increases and consumption decreases.
  4. Entrepreneurs invest in means of production that are more round about and longer, to be more efficient.
  5. Thus, there are more orders of production.
  6. And thus, there are more resources:
    • More people are involved in higher orders of production than before.
    • Less people are involved in lower orders of production than before.
  7. Production become more efficient.
  8. Hence, the increased efficiency allows for consumption and investment, shifting the PPI curve outwards.


When the State Artificially Lowers Interest Rates, the Boom-Bust Cycle Occurs

  1. The State creates more credit, allowing banks to loan out money on a fractional reserve basis by a ratio of say 1:10 (pyramiding), on top of their initial printing of money (inflation).
  2. The extra loanable money floating around causes the supply curve for loans to shift rightward and downward:
    • The interest rate (price) of loans drops.
    • The quantity of loans increases.
  3. The banks loan out credit to businessmen, who use it to buy capital goods. The businessmen are in fact malinvesting that new extra money, diverting it from projects to which it would otherwise have gone, towards projects to which it would otherwise not have gone.
  4. Aggregately, there isn't enough physical capital goods to complete all of these projects:
    • Some projects will be complete.
    • Some projects won't be complete.
  5. The government keeps pumping in credit.
  6. Though the new money hits the banking system first, and then companies get it, the new money slowly gets around the economy, causing prices to rise in non-uniform fashion.
  7. People start adding a large inflation premium to loans than they had before. If the State wants to keep the boom going year after year, it has to pump in even more money, at an even faster rate.
  8. This can lead to hyper-inflation and a crack-up boom. However, normally that is not the case. In any event, this is unsustainable:
    1. Businessmen eventually realize:
      • There isn't enough demand to sell what they're making.
      • They don't have the resources to complete the product.
    2. They then liquidate these malinvestments.
    3. This is the bust.

    Alternatively, if the State stops pumping in credit and new money, the artificial boom stops and the malinvestments are revealed and liquidated (this is the bust). The bust is actually good, as it liquidates wasteful employment of resources (malinvestment), and reallocates those resources towards more highly wanted ends.


Milton Friedman's "Plucking" Objection and Garrison's Response

  • Milton Friedman's objection to the Austrian theory of the business cycle (the "plucking" objection):
    • If the Austrian model is true, there should be a high correlation between a peak (of the GDP) and a recovery.
    • The bust should happen quickly after the upturn.
    • However, Friedman found no correlation between rise and fall.
    • There could be long rises without falls.
  • Garrison's response:
    • In reality, the GDP only goes up a little bit above sustainable production.
    • However, it then falls way below the sustainable rate of production.
    • Thus, Friedman's objection doesn't rule out the ABC (though it did suggest the line of thought leading to that insight).

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