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Austrian business cycle theory and monetary equilibrium

February 3, 2016
in Blog

As Steve Horwitz has shown, the insights of Austrian macroeconomics and monetary disequilibrium theory can be combined to yield a powerful paradigm for understanding how monetary policy affects the economy.  Crucial to this synthesis is the neutrality of money.  Remember that money is neutral when it facilitates exchange, but does not distort the terms of exchange.  Money is approximately neutral when conditions of monetary equilibrium hold—when individuals’ demands for money equals the supply of money at the going price level, which itself gives us information about the ‘price’ of money.

When monetary disequilibrium exists due to an excess supply of money, Austrian-like dynamics can result.  Assuming a central bank injects the newly-created money into capital markets, and that this monetary injection was not anticipated, the wedge driven between the natural and market rates of interest will facilitate a miscoordination between consumption and investment.  This miscoordination will manifest in incompatible production and consumption plans.  Eventually this must result in a bust, and the economy must grope back towards sustainable production and consumption processes.

What the monetary disequilibrium insights add is an understanding that monetary non-neutrality does not necessarily follow from any increase in the money supply.  Monetary equilibrium can be dynamic—so long as the money supply is growing at the same rate as market actors expect, ABCT-esque malinvestments will probably not result.  Note that this result is compatible with constant inflation.  If the money supply is growing at 5% every time period, and money demand only grows at 2%–in line with population growth, perhaps—then the result will be ‘steady state’ inflation of 3% per time period.  Thus ‘ordinary’ monetary equilibrium, with quantity of money supplied equaling quantity of money demanded at a specific, and unchanging, price level, is a special static case of the more dynamic model.

It is when money growth unexpectedly diverges from a trend growth path perceived by the market that we begin to observe problems.  If the rate of money growth slows down unexpectedly, there can be a temporary downturn until market actors adjust market prices to reflect the new, slower rate of money growth.  If the rate of money growth increases unexpectedly, we’re back to the start of the ABCT story.

Incorporating ABCT into monetary disequilibrium theory is important because it gives us a more general framework for understanding how monetary factors relate to macroeconomic fluctuations.  Not all increases in the money supply have resulted in boom-bust cycles; not all falls have resulted in painful deflationary spirals.  The compound theory highlighted above is a parsimonious explanation of why.

3 Comments

  1. Supply Chain May 10, 2016 6:56 PM

    Great article, it is not often that you can say that about a post on Austrian business cycle theory.
    Thanks
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  2. Pablo Paniagua February 18, 2016 10:06 AM

    I have a couple of doubts concerning your argument about the expectational dynamic sense of monetary equilibrium. Monetary equilibrium in the static sense is about meeting the demand for money or counteract changes in velocity to avoid money affecting prices. Now you say that dynamic monetary eq. can be maintain as long as it achieves a growth path equal to the expected path by individuals (like a sort of Lucas neutrality). You say that monetary equilibrium can be maintain in this sense and still have inflation as long as it is predictable or expected by the economic actors. If this condition of dynamic monetary eq. holds then why not having a money growth rate fully credible at 10% so given a demand of 2% we have a steady expected path of inflation of 8%, would that still be consistent with dynamic neutrality? if yes then lets have a predictable and credible path for 20% inflation or higher since it is still neutral it shouldn't matter. Furthermore if we believe that during the 2000s the Fed policies helped to create a sort of ABCT unsuitable growth path in housing while inflation expectations in the words of Bernanke well 'well anchored' then how is that historical episode consistent with dynamic monetary equilibrium?.

    It seems to me that this dynamic expectational sense of monetary equilibrium is a 'crude' form of monetary equilibrium since it is not really related to equalising the actual or expected demand for money with offsetting changes in its supply. This 'crude' aggregated form of neutrality might stabilise expectations of a stable credible path of inflation, but it seems to me that it might still hide micro unpredictability of how local prices and relative prices might behave under that environment. Economic actors after all might now the stable path of inflation but they might still not know how actual local relative prices will behave in the face of that inflation and heterogenous productivity changes. Horwitz (2011) makes a similar point when discussing a stable predictable path of zero inflation against Buchanan's proposal saying that is a 'crude' form of stability.

    I would love to hear your thoughts on these issues.

  3. Pablo Paniagua February 18, 2016 9:44 AM

    I have a couple of doubts concerning your argument about the expectational dynamic sense of monetary equilibrium. Monetary equilibrium in the static sense is about meeting the demand for money or counteract changes in velocity to avoid money affecting prices. Now you say that dynamic monetary eq. can be maintain as long as it achieves a growth path equal to the expected path by individuals (like a sort of Lucas neutrality). You say that monetary equilibrium can be maintain in this sense and still have inflation, as long as is expected and stable. In your example 3% and you say that under this stable predictable path of inflation "ABCT-esque malinvestments will probably not result." If this is the case then why not having a money supply growing at 10% and making it fully credible so (given a demand for money of 2%) we have a steady state of inflation of 8% would that be also monetary equilibrium? Furthermore if we believe that during the housing boom the Fed did encourage some malinvesments while having a fairy stable inflation expectations of 2% during that decade; then how is that ABCT example in housing while anchored inflation expectations consistent with your view of the dynamic monetary equilibrium?.

    It seems at least to me that that expectational form of monetary expectational stability is a 'crude' aggregated form of monetary equilibrium. Individuals might have a predictable and stable growth path of the supply of money as an aggregate and also of inflation but that does no mean that they will know how local prices and relative prices on specific sectors will behave under that regime. It does not seems to avoid microeconomic unpredictability on prices and it might still leads to some ABCT-esque malinvestments.

    I would love to hear your thoughts on this,