Business Cycle


Friedrich Hayek - The business cycle



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Friedrich Hayek - The business cycle

  • Also in 1931, Hayek critiqued Keynes's A Treatise on Money|Treatise on Money (1930) in his Reflections on the pure theory of Mr



Friedrich Hayek - Business cycle critiques

  • Others who responded negatively to Hayek's work on the business cycle included John Hicks, Frank Knight, and Gunnar Myrdal.Bruce Caldwell, Hayek's Challenge: An Intellectual Biography of F



Friedrich Hayek - Business cycle critiques

  • Lionel Robbins himself, who had embraced the Austrian theory of the business cycle in The Great Depression (1934), later regretted having written that book and accepted many of the Keynesian counter-arguments.Roger Garrison|R



Friedrich Hayek - Business cycle critiques

  • Hayek never produced the book-length treatment of the dynamics of capital that he had promised in the Pure Theory of Capital



Austrian School - Business cycles

  • The Austrian theory of the business cycles|business cycle (ABCT) focuses on banks' issuance of credit as the cause of economic fluctuations. Although later elaborated by Hayek and others, the theory was first set forth by von Mises, who believed that banks extend credit at artificially low interest rates, causing businesses to invest in relatively Roundaboutness|roundabout production processes. Mises stated that this led to a misallocation of resources which he called malinvestment.



Austrian School - Business cycles

  • According to the theory, malinvestment is induced by banks' excessive and unsustainable expansion of credit to businesses.[http://www.econlib.org/library/Mises/msT.html Theory of Money and Credit], Ludwig von Mises, Part III, Part IV Businesses borrow at unsustainably low interest rates and overinvest in capital-intensive production processes, which in turn leads to a diversion of investment from consumer goods industries to capital goods industries



Austrian School - Business cycles

  • According to the Austrian view, the proportion of income allocated to Consumption (economics)|consumption rather than saving is determined by the interest rate and people's time preference, which is the degree to which they prefer present to future satisfactions



Austrian School - Business cycles

  • Newly extended credit thus malinvested will circulate from the business borrowers to the factors of production: landowners, capital goods producers, and capital goods workers



Austrian School - Business cycle theory

  • According to John Quiggin, most economists believe that the Austrian business cycle theory is incorrect because of its incompleteness and other problems. Economists such as Gottfried von Haberler, Milton Friedman, Gordon Tullock, Bryan Caplan, and Paul Krugman have argued that the theory is incorrect.



Welfare cost of business cycles

  • In macroeconomics, the 'welfare cost of business cycles' refers to the decrease in social welfare, if any, caused by business cycle fluctuations.



Welfare cost of business cycles

  • Nobel Prize in Economics|Nobel economist Robert Lucas, Jr.|Robert Lucas proposed measuring the cost of business cycles as the percentage increase in Consumption (economics)|consumption that would be necessary to make a representative agent|representative consumer Preference#Preference in economics|indifferent between a smooth, non-fluctuating, consumption trend and one that is subject to business cycles.



Welfare cost of business cycles

  • Under the assumptions that business cycles represent random shocks around a trend growth path, Robert Lucas, Jr.|Robert Lucas argued that the cost of business cycles is extremely small, and as a result the focus of both academic economists and policy makers on economic stabilization policy rather than on long term economic growth|growth has been misplaced



Welfare cost of business cycles

  • Under this viewpoint, the welfare cost of business cycles is larger, because an economy with cycles not only suffers more variable consumption, but also lower consumption on average.



Welfare cost of business cycles - Basic intuition

  • If we consider two consumption paths, each with the same Trend estimation|trend and the same initial level of consumption – and as a result same level of consumption per period 'Mean|on average' – but with different levels of variance|volatility, then, according to economic theory, the less volatile consumption path will be preferred to the more volatile one



Welfare cost of business cycles - Lucas' formula

  • Robert Lucas' baseline formula for the welfare cost of business cycles is given by (see mathematical derivation below):



Welfare cost of business cycles - Lucas' formula

  • where \lambda is the cost of fluctuations (the % of average annual consumption that a person would be willing to pay to eliminate all fluctuations in her consumption), \sigma is the standard deviation of the natural log of consumption and \theta measures the degree of risk aversion.






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