Austrian Business Cycle Theory

Instructor: Tyler Cowen, George Mason University

This is " Game of Theories: The Austrians " from our Principles of Economics: Macroeconomics course. The Austrian school of economic thought emphasizes market price

This is "Game of Theories: The Austrians" from our Principles of Economics: Macroeconomics course.

The Austrian school of economic thought emphasizes market price signals and how they communicate decentralized information in an economy. The Austrian business cycle theory focuses on how central banks can distort those price signals.

When central banks increase the money supply, inflation goes up. This pushes market interest rates down and credit becomes easier to obtain. According to the Austrians, the market has been distorted in this scenario by central bank interference.

Now imagine you’re an entrepreneur. Interest rates are around 5%. There are a lot of investments that would be appealing to you if interest rates were just a little lower. Now let’s say that, due to an increase in the money supply, interest rates drop to 1% and you make your investments.

According Austrian business cycle theory, these investments only seem more profitable because the market price signal has been distorted. But many entrepreneurs like yourself will have invested in building more homes, factories, etc. It will turn out that the demand for those homes and factories wasn’t actually that high. Investments will be liquidated. Workers will be laid off. So we have a boom full of malinvestment, followed by a bust.

Interest rates can lower through market forces, but it’s a result of consumer saving – not the central bank’s actions. So under “normal” circumstances, the lower interest rates would be a signal to entrepreneurs that it’s a good time to invest in these projects. The problem, according to the Austrians, is that consumers haven’t been saving more when interest rates lower from the central bank interference. The demand isn’t there because savings in the economy are insufficient.

Where does the Austrian business cycle theory fall short? It doesn’t explain how so many entrepreneurs are tricked by the central bank. It also doesn’t really deal with why busts are so painful. It may have to borrow from other theories (e.g., monetarist or Keynesian) to deal with the high unemployment we see during recessions. It also implies that consumption and investment move in opposite directions. However, the data shows that they tend to move together.

Austrian business cycle theory does explain some features of booms and busts, but it remains to be seen whether it can be a more fundamental explanation.


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