Knut Wicksell developed a model for understanding price movements based on the divergence of the observed bank rate of interest and marginal productivity or capital or lets say the profit rate. variations of this idea was developed by the Austrian school of economics to explain business cycles. That is disequilibrium in the monetary markets create disequilibrium in the real sector, a business cycle.

why prices change

A simplified version of Wicksell’s theory of price changes

Although Wicksell was more concerned about explaining changes in prices caused by the the divergence of the general profit rate, the rate of return of an entrepreneurial activity in relation to the bank rate of interest or the charge for business credit, I look at it as a very good explanation for why an economy experiences a boom and bust cycle or recession. His economic theory was a framework for modern business cycle theory.

If I were to choose one explanation for why we are in the great recession, I would nominate, the monetary shocks cause disequilibrium in the real sector. That is the Federal reserve lowing the rate of interest so low, that the economy bubbled and burst. When the Fed and Fiscal action tried to inflate the balloon again, with similar measures, it would not inflate because there was a hole in the balloon.

expecational business cycle theory

The basic idea of why markets go crazy and why ‘in the day’ we were all winners and borrowed even after signs of weakness in the economy; not because we were irrational about our choices, but simply the expected profit was greater than the cost of borrowing.

Enter Wicksell’s theory with rational expectations. If you extend Wicksell’s theory of prices to expectations of the marginal productivity of capital, that is the the expected profit rate, rather than an observed profit rate, then entrepreneurs do not want to expand based on uncertainty of profit in the future. The more uncertainty there is it has a dampening effect on profit.

For example in simplified terms, if there is a current 10% profit on capital, and interest rates are 5%  you would think there might be growth. You could borrow at 5% and earn 10%. Yet investors are leery and do not go to the bank to take a loan.  Why?

This is because the term of a loan is lets say 30 years and expected profit over the life of the loan is only 6%, yet the variance cause by uncertainty might be 3% to 8% and since investors are risk averse (statistically),  business owners would rather not take the risk. So it is not the profit rate today that counts but the expected profit rate, but also factored for uncertainty.

Ways to prevent trade cycles

  • The only way for a market to achieve long term growth is by letting the markets work. This could include the elimination of the central bank and free money.
  • If government really must monopolizes the money supply a gold standard would provide expectational stability and less the chance of a monetary shock.
  • Business cycles would come about even if the monetary world of interest and prices were in equilibrium because economic research shows statistically there are most likely a number of causes to business cycles. However, I would nominate monetary disequilibrium  with an expectational component as the primary cause.

What Wicksell really said about business cycles before the Austrians expended his price theory

Wicksell’s theory of business cycles was based on real factors and was somewhat Malthusian. Wicksell explained recessions and recoveries a function of shocks and variances in technology, discoveries, population and the capital stock. Remember the economic theory of Knut Wicksell was concerned with Wicksellian ideas like the natural rate of interest, the cumulative process, the neutrality of money, in the short and the long run and a pure credit economy were discusses to explain problems of deflation. It was Gunnar Myrdal and Erik Lindahl that developed the idea of monetary equilibrium. It was Misses and Hayek that extended this.