The basic outline of Austrian macroeconomics and business cycle theory described above will now be elaborated. A three part analysis, using the loanable funds market, the production possibilities frontier, and the Hayekian triangle to model the intertemporal production structure, will be employed to this end.
Capital Based Macroeconomics
Austrian macroeconomic theory is based on the market process, as the result of individual actions, in the context of the intertemporal capital structure. Focusing on the intertemporal nature of capital allows this theory to capture the two pervasive elements in macroeconomics, time and money, where other theories can’t. In so doing, it rejects the Keynesian theoretical division between macroeconomics and the economics of growth. Mainstream macroeconomics studies economy-wide disequilibria with a focus on aggregates in a short term setting. Growth theory studies a growing capital stock and its consequences in the long term. Austrian macroeconomics, being capital based, combines the study of the short term macro, cyclical changes in the economy with the long run secular economic expansion due to a growth in capital.
This capital based approach has three integrated elements: the market for loanable funds, the production possibilities frontier, and the intertemporal structure of production, where the market process is guided by the attempted match, by entrepreneurs, between consumer preferences and production.
The Loanable Funds Market
Austrian theory defines a loanable funds market with some modifications. Consumer lending is netted out on the supply side. The supply and demand of loanable funds is broadened to include retained earnings, which are simply a fund with which a business lends to and borrows from itself. The purchase of equities, which in this context are closely related to debt instruments, is considered a form of saving.
The supply of loanable funds is defined as total income not spent on consumer goods, but instead used to earn interest or dividends. In other words, investable resources. Loanable funds are used to invest in the means of production, not in financial instruments. Demand for these funds reflects businesses’ desires to pay for inputs now in order to sell output later. Supply represents that part of income foregone by consumers for the consumption of goods now in order to save for more consumption later. The supply/demand equilibrium coordinates these actions.
The investment of loanable funds brings the loan rates and the implicit interest rates among the various stages of production in line. As more investment goes to those stages with temporarily higher returns, those stages are brought in line with the implicit rates in all other stages and the loan rate, so all rates tend to equalize. The loan rate includes the expected return. In this way it differs from the pure rate of interest, which is a reflection of societal time preferences.
Keynesian macroeconomics hints at psychological explanations for economic fluctuations. Business confidence is described as the “waxing and waning of animal spirits”. The other side of the coin from business confidence is the saver’s “liquidity preference”. Austrian theory eschews these psychological explanations and instead focuses on economics. Business confidence is assumed to be usually stable, and an economic explanation for expected losses from intertemporal discoordination is desired. For savers, the concept of liquidity preference is discarded in favor of an economic explanation of lender’s risk, which, as with business confidence, is assumed to be usually stable.
As alluded to above, mainstream macro has two conflicting theoretical constructs: one for short run equilibrium/disequilibrium and another for long run economic capital accumulation and growth. The idea of saving as not consuming is important for the short run consumption-based theory. Saving and decreased consumption are assumed to be permanent by businesses in the short run theory. The paradox of thrift enters the picture here as savings won’t be fully borrowed for investment in production due to business pessimism. For Keynesians especially, what appears to be disequilibrium is really an equilibrium with unemployment and is the normal course of things. The long run theory, however, views saving and investment as the foundations of growth.
Austrian theory falls somewhere in between these two constructions. People don’t just save; they save for the purpose of consuming more later. They accumulate purchasing power for later use. There is, of course, risk and uncertainty inherent in future demand for consumption goods. The entrepreneur takes on this risk as he tries to earn a profit from the coordination of current saving and future demand. The entrepreneur, then, is crucial in the Austrian theory.
The Production Possibilities Frontier
The Production Possibilities Frontier (PPF) can be used to show the tradeoff between consumption (C) and investment (I), rather than the tradeoff between consumption and capital goods as is normally done. This modified use of the PPF captures gross investment, including capital maintenance and capital expansion. The production of capital goods is equal to investment in any given period. A stationary economy, with no growth and no contraction, has gross investment at a level only to maintain capital.
A PPF describing a mixed economy must also capture government spending (G) and taxation (T). Conventional, Keynesian-based, macroeconomics defines total expenditure (E) as C + I + G. In the Keynesian framework, consumption is stable, investment is unstable, and government spending is a stabilizing force. Consumption depends on net income, but investment and government spending do not. Investment has a mind of its own, so to speak, so Keynesian policy calls for G to counteract changes in I to allow for stable growth.
The particular design of the tax system and the types of government spending, whether that money goes to domestic investment or foreign military activities or so forth, will affect the shape of the PPF and the specific point of the PPF an economy will find itself. Of course, governments often spend more than they bring in and finance the difference with debt. This borrowing increases the demand for loanable funds, and government deficits, Gd, are added to investment, I, on the PPF’s horizontal axis. Gd is defined as G – T.
In a private economy or an economy with G = T, the net PPF shows the sustainable combinations of C and I and assumes full resource employment. Points inside the PPF have unemployment of labor (L) and resources. This is considered the normal state of affairs in a private economy by Keynesians, where scarcity will not impede growth and C and I can move in the same direction. In fact, Keynes’ General Theory includes points inside the PPF, and the theory considers points on the PPF to represent a special case, where Classical theory describes the economy well.
Representing the Intertemporal Structure of Production
Capital-based macroeconomics can make use of the Hayekian triangle to make a simple illustration of both the value added between production stages and the time dimension of the capital structure. The horizontal leg of the triangle is production time, the vertical leg is the value of output, and the slope of the hypotenuse represents value added between stages. The simplest, point input/point output, case, such as putting a food in storage before selling the more valuable aged product, contains one stage. The triangle can be divided vertically to represent different production stages. Consumption of consumer durables can be represented by another triangle back to back with the first, where the slope of its hypotenuse represents consumption through time.
The Macroeconomics of Capital Structure
Austrian macroeconomics combines the three part analysis described above. The interest rate and the return on capital tend toward each other, so the slope of the Hayekian triangle and the interest rate normally move in the same direction in the absence of government spending and borrowing and other economic interventions. The location of the economy described by the three part analysis on the PPF gives us that economy’s “natural” rate of employment, and the clearing rate of our loanable funds market gives us the “natural” rate of interest.
The supply and demand of money is not explicitly represented in this analysis, so transaction demand and speculative demand for money are not a part of Austrian macroeconomics. The model of the economy, absent government intervention, is a system where money simply facilitates trade and is not a source of disequilibrium. As such it is “pure” theory, and not monetary theory. Finally, this method does not track the absolute price level, and instead focused on relative prices as the more important factor in the intertemporal coordination of production.
Austrian Business Cycle Theory (ABCT), on the other hand, treats money as a “loose joint”, where policy-induced money supply and interest rate changes cause economic disequilibria. As such, ABCT is a monetary theory. Keynesians consider the Real Balance Effect, where an increase in money’s purchasing power causes increased consumption, the only possible, though highly unlikely, market solution to economic depression. Austrian macroeconomics counters by using the Capital Allocation Effect, where movements in relative prices within the capital structure allow for intertemporal resource allocation and societal consumption preferences to be in line without idle labor or resources. Also unlike Keynesian macroeconomics, Austrian macro does not include “the” labor market. Instead, many labor and resource markets are represented, with labor and resources moving between different stages as needed.
Macroeconomics of Secular Growth
A static economy is easily applied using the three part analysis of the PPF, the loanable funds market, and the Hayekian triangle, but secular growth is the more general case. During growth, we have outward shifts of the PPF. At the same time, societal time preferences might not have changed, so the interest rate can remain the same, and with it the slope of the Hayekian triangle, as the supply of and demand for loans both increase. Historically, though, increases in wealth generally bring decreased time preferences, so the supply of loanable funds will outpace their demand, causing interest rates to fall. Put another way, consumption increases at a slower rate than income since saving and investment also increase with rising income.
The equation of exchange, MV = PQ, where Q = C + I, implies that the general price level declines as consumption and investment increase. Secular growth will bring lowered prices and wages in the sectors experiencing the growth with a given money supply and velocity. This growth-based deflation does not bring disequilibrium, unlike deflation caused by changes in the supply and demand for money. Growth brings greater saving and investment, which allows for a lengthening of the production structure and an eventual fall in the prices of consumer goods.