Teaching Austrian Business Cycle Theory and Macroeconomics

0:00The objectives of this presentation are twofold. First is to argue that Austrian business cycle theory offers unique pedagogical advantages over conventional presentations in mainstream principles texts. Second, I will make the case that Austrian business cycle theory is the logical and necessary conclusion which follows from a set of fundamentals which virtually all mainstream economists accept in isolation, but they are mysteriously unable to connect the dots to arrive at the conclusions promoted by our heretical cult. The presentation will consist of three elements, the loanable funds model, the production, and let me say that I agree with everything that Rayno presented.

0:52It's just that my point here is that most mainstream economists would not criticize this model. So it's a good foundation for them to accept. The production possibilities frontier and the Hayekian Triangle. The first two are not controversial, at least outside the Austrian School, and not necessarily Austrian. Although the Hayekian Triangle is widely rejected as a plausible model of production structure or simply considered outdated, it has particular uses which are amenable to conceptualizing entrepreneurship. This is the loanable funds model. We observe individual time preference varies. If we set the interest rates sufficiently low, few offer to lend much of their wealth, but many would want to borrow.

1:40This incidentally would result in the interest rate rising. If we set the interest rates sufficiently high, many would want to lend, but few borrow, resulting in an interest rate adjusting downward toward equilibrium. Because the supply curve slopes upward and the demand curve slopes downward, The equilibrium is stable and we have a model of the joint determination of the equilibrium interest rate R0 and the equilibrium amount loaned and borrowed L0. We can make the further observation that when the interest rate is zero, no one will want to lend and everyone will want to borrow. But if the interest rate rises enough, everyone will want to lend, but no one borrow. Thus, the supply and demand curves are jointly determined by the distribution or constellation of individual time preferences, and demand is just the mirror image of supply.

2:34If we increase the money supply, we increase the supply of loanable funds without changing the demand. The interest rate now falls below the original rate, which was determined by the society's overall time preference constellation. Also, investment rises, but saving falls, or in other words, monetary expansion has two effects. It A, drives a wedge between interest and time preference, and B, drives a wedge between investment and saving. This is not controversial and is widely accepted in the mainstream. Now we turn to the production possibilities frontier. This shows us different amounts of goods A and B, which we can produce depending on how and how we allocate productive resources. It is normally bowed outward as long as factors are heterogeneous.

3:22Some resources are more useful for producing A as opposed to B. We can capture the whole economy in the PPF diagram if we make the two goods producer goods I for investment and consumer goods C for consumption. If we graph I on the vertical axis, we can represent the slope of the tangent as the rate of time preference. If time preference is zero, the tangent is flat and selects the I-intercept, the maximum possible output of producer goods or investment expenditure. If time preference is infinite, the tangent is vertical and selects the consumption intercept. Time preference may be low, which implies a higher growth rate, which would be represented by shifting the PPF outward.

4:12Time preference may be high with a steep slope, implying a lower growth rate and possibly even a negative one. So far we have assumed no monetary expansion and that the market interest rate from the loanable funds market reflects agent time preferences. We've seen in the loanable funds model that monetary expansion drives a wedge between interest and time preference, that is that time preference is unchanged but the market interest rate has been lowered. Saving the interest rate should result in producer goods being substituted for consumer goods output. This is virtuous and should result in faster economic growth. That would be fine if that were all that happens. The lower interest rate increases investment to an expansionary level greater than the amount saved by consumers. Because saving falls in response to the lower interest rate consumer spending also rises. The economy is drawn beyond the PPF to an unsustainable point beyond it where a recession Sessionary Correction becomes inevitable.

5:16In the absence of monetary expansion, the interest rate reflects agent time preferences selecting the one sustainably attainable combination of consumer goods satisfying immediate wants and producer goods potentially satisfying future wants. If time preference falls, this results in a substitution of producer goods for consumer and as producer goods become more abundant, the economy's productive capacity grows. This works fine as long as it doesn't result from monetary expansion. As we saw from the loanable funds model, increasing the money supply lowers the interest rate R below the rate of time preference P0.

6:04I rises to IE for expansionary investment consistent with the lower interest rate as C rises to CE, expansionary consumption. This happens because savings falls in response to the lower interest rate causing consumption spending to rise. The economy is drawn unsustainably outside the frontier. The correction brings the economy back down under the frontier because lots of productive of Resources have been wasted during the unsustainable expansion. We can illustrate the Hayekian Triangle within the production possibilities frontier, but we have to note that the height of the triangle is consumption, because I've reversed the usual way these are shown. So as a result, the height of the triangle here is actually the base in most presentations.

6:55The unsustainability of this production structure is illustrated by its curved linear shape indicating that middle-stage bottlenecks prevent low-yielding early-stage investment from being transformed into high-yielding late-stage consumer goods. Following Garrison, we can use this framework to illustrate alternative explanations of the business cycle. The Keynesian otherwise inexplicable collapse of aggregate demand is illustrated here. Keynes' plucking model of the business cycle is formally identical. Interestingly in the general theory, Keynes argues that to aid recovery, interest rates should be lowered to restore investment spending. This would either move us to the left on the PPF or bring about an Austrian recession.

7:43Hardly a good outcome. Real business cycle theory operates in an interest and time preference free zone. Human but serially correlated shocks to factor productivity shift the PPF inward. Though this phenomenon can be identified as a recession, it is also a purportedly welfare optimal outcome, which would be news to anybody who's unemployed during a recession. It is hard to see these alternatives as very impressive compared with Austrian business cycle theory. Hyman Minsky's post-Keynesian financial instability hypothesis fares better in this framework. Factor productivity and the return on financial assets are both stochastic and serially correlated.

8:30As an expansion lengthens, investors and entrepreneurs lose the memory of the last collapse. They progressively under appraise economic risk to sigma zero, which shrinks as time goes by, while they're increasingly risky, over-leveraged and financially interdependent and Interconnected Behavior increases the unobservable actual risk to Sigma 1 until a shock disrupts many financial arrangements and assets are revalued downward in an effort to generate liquidity, a process Minsky calls debt deflation. Minsky does not relate his scenario to monetary expansion, but it seems clear that monetary expansion would both encourage, aggravate and fund the kind of irresponsible over-leveraging he describes in the financial instability hypothesis.

9:22He does not relate an unsustainable increase in investment with a reduction in saving. I hope I have made a persuasive case to you both for the reality and for the pedagogical of Austrian Business Cycle Theory for teaching macro principles and a few more advanced topics. There is very little in macroeconomics which has not been addressed through this model. It thus remains a mystery why Austrian Business Cycle Theory is not enthusiastically embraced by the mainstream. They have all the pieces, why can't they connect the dots? Israel Kirzner often makes the case that much of Austrian economics has been thoroughly assimilated into the mainstream. However, a coherent, integrated macroeconomics has yet to find real acceptance in spite of its holistic, consistent, integrated and thoroughly uncontroversial basis.