rsus Hayek business cycle theory

Keynesian vs. Austrian Business Cycle Theory – Explained

I often ask my class to compare the Keynesian explanation for the business cycle compared to a monetary or Austrian explanation of a business cycle. I am primarily looking for the theory, rather than policy recommendations. I am looking for objectivity and positive economic analysis.

Here are my class notes summarized in pdf. If you need to study for an exam or just want to understand the ideas quickly you can download them here. This simple list of economic keywords. It is only a summary table.

Download Keynesian and Austrian Business Cycle Theory in PDF:

For a verbal discussion on the subject read the post below.

Funny answers my students give me in the Keynes versus Hayek debate

I often read and hear “Yeah man, Keynes was for big government and Hayek believed the government should stay out”. Then they apply some normative statement connected to what they think is right based on opinion. “Dude, Keynes man, he was bad”.

That is basically correct, however, I am really looking for the theory behind this. Why did the economists of the Keynesian school of thought and the Austrian school of thought come to come to different theoretical conclusions? It is the economic theory that brings you to a conclusion and even an economic ideology. Therefore, I am concerned with an objective non-basis statement of the theory as they understand it. In fact, sometimes I disallow students to use the word ‘government’. It is a too general cliche word. Better would be to go into fiscal or monetary policy.

Depending on which hat I wear that day, I would argue either the Keynesian or Austrian ideas, and sometime even suggest a synthesis. However, a synthesis as understood in today’s terms is really a Keynesian model. Full disclose, I come from a more Austrian perspective.

Regardless, I want my students and my readers to be able develop critical thinking. At the end, I want people to weight the evidence and perhaps draw some conclusions based on which theory is more logically rigorous and what the empirical evidence suggests. Being objective and impartial needs to be the stance from the start so even when you have a conclusion you can better defend it as you understand both sides.

Lucky, I find politics boring, this is why I prefer the theory over the prescription.

Lets get right into it.

How Keynes explained the business cycle


Keynesian economics is an under-consumption model and explanation for the business cycle based on under-consumption. In the Y=C+I+G equation, C or consumption is the biggest component. Many people think G or government is, however, it is C. G is the most stable and I, Investment is the driver behind business initiatives and sensitive to interest rates.The reason C fell or falls is because Keynesian economics is an under-consumption model and explanation for the business cycle based on under-consumption. In the Y=C+I+G equation, C or consumption is the biggest component. Many people think G or government is, however, it is C. G is the most stable and I, Investment is the driver behind business initiatives and sensitive to interest rates.

Say’s law

Keynesians believe if C is the largest component, the lifeblood of the economy there is where the focus of the theory is. In contrast to Say’s law, Keynes believed demand creates its own supply. If people demand something business will respond and bring it to market. If consumer demand falls then business will have to cut back. Objectively this makes sense.

Aggregate Demand and Aggregate Supply model

If you look at the AD and AS model this would be seen in shifts in the AD curve. The long-run AS curve being vertical and AD moving to the left or right depending on decreasing or increasing consumer demand.

How Animal Spirits leads to unemployment

‘Animal Spirits‘ , a version of consumer confidence, is a primary a driver in the fluctuations in GDP. The AD curve will fluctuate. What happens next is a domino effect. Whether you see it as a negative multiplier or the paradox of thrift, that is people are allocating money from spending to savings the end result is spending falls. Firms feel the pull back in demand, and adjust their production. This ultimately is equated to unemployment. Profit-maximizing firms need to lay off workers because of lagging sales and fixed cost.

They could reduce workers wages , which is a cost of labor price adjustment. However, workers tend not to accept wage reductions either because of explicate contracts such as labor unions or implicate contracts or an general understanding.

Think about it, if your boss told you, sales were down a little, we will cut your salary by 20% would you agree? You personally have non-discretionary payments like your mortgage and car payments that you could not make. The usually scenario is a simply layoff.

When you are unemployed you personally will be spending less. For example, you will order less on Amazon and perhaps opt for a Netflix night watching Portlandia instead of a weekend trip to Portland. This means you are spending less and the economy as a whole starts to experience an inverse multiplier effect. That is, you spend less and business make less and have to lay off more people. The unemployed have less money and people again spend less and the result is business spending and employment is depressed. You have a recession or a depression.

The stickiness of wages and slow price adjustments cause the economy be to stuck outside equilibrium or in a less than optimal equilibrium. In other words, information and coordination lags affect price adjustments back to equilibrium.

Money in Keynesian theory

Money in the original Keynesian models played a relatively subsidiary role. It was connected to the liquidity preference and hoarding of money. Keynes introduced the idea of a liquidity trap, which no matter what the rate of interest people preferred to hold money rather than spend it.

Money’s role in the economy was essentially about spending and again, the C component in the Y=C=I+G equation. The problem was because of market failures money and spending was not flowing, not in a circular way or any way.

GDP in aggregate falls

The end result is you have an aggregate fall in GDP. Again this is aggregate. Aggregate is not be equated with individual people and markets. Just because the aggregate is down does not mean individuals are not prospering and making money. People who can adjust and adapt are the agents that bring markets back to equilibrium.

The Keynesian Solution

The ultimate solution is to increase G and this will create a money multiplier. Whether it is digging ditches, war, or paying the glass man to fix broken windows. If the engine has stalled you need to give it push.

Alternatively Keynesians do not mind monetary stimulus, low interest rates. It does not not matter just get spending flowing. It does not matter debt or deficits or Federal Reserve stimulus. When the economy is down turn the dials and micro manage the free market that has failed.

All you have to do is spend. The paradox of thrift needs to be eradicated, now get out there and spend money, it does not matter how.

How the Austrians explained the business cycle

The Austrian business cycle theory, or ABCT is a monetary theory of the business cycle. Specifically disequilibrium in the money market creates disequilibrium in the real sector. It is the boom that is the cause. A boom cause by a monetary policy that expands credit inappropriately for the level of real savings. Credit expansion should correspond to a real savings level. Instead, in a boom it is related to the Federal Reserve mis-guessing the interest rate and ‘creating money out of thin air’. This creates a distortion of the capital lengthening and formation process.

Do not worry about what that means now, it will become apparent latter.

Lets look at money and the real world then why and how their interrelationship is the basis of the Austrian Business Cycle theory.


Money has been something that has evolved as a tool to satisfy the double coincidence of wants. A barter economy simply could not achieve the same level of efficiency in satisfy wants. Therefore, people started to spontaneously and organically use commodities that functioned as a medium of exchange and most efficiently satisfied the double coincidence of wants. Initially it was such things as shells or salt (hence the word ‘salary’) and eventually it evolved into metals such as silver and ultimately gold.

The important point is, it is not that gold was chosen, rather, people just started to use it as it worked the best. Money evolved to be what people use as a medium of exchange.

Economics of supply and demand

Basic economics is about the supply and demand for a particular good. For example, the price of potatoes is determined by the market forces of supply and demand.

If I bring potatoes I grow in my backyard to market for price of 3 (dollars or Euros) a basket, the market will tell me what if the price of 3 is correct. If I sell everyone and I am happy, with the price, this is a natural equilibrium.

If I sell my potatoes for 1 penny and I sell all I have, this would most likely not cover my cost.

If I sell my potatoes for 100 dollars I will not sell them.

My point is I find a market clearing price. The market clearing price ex post will be the equilibrium price.

The point being supply and demand work out disequilibrium quickly though the price mechanism.

There is no market for money

Every commodity, including capital goods works out disequilibrium through an adjustment in prices. However, money has no market, so it works out its equilibrium across all markets. This is because money is the second half of every transaction. Adjustments to equilibrium for money is seen across every market.

These adjustments can come in the form of adjustment to price, the price level such as monetary inflation or deflation. It also can come in the form of a business cycle, that is fluctuation from GDP away from the optimal, that is an output gap.

Therefore, a monetary theory and policy that is money neutral is important for an economy to achieve a high growth path and optimal equilibrium.

Interest rates an Monetary Theory

The old theory of money was the quantity theory of money for example David Hume, and its resurrection by Milton Friedman.

Austrian monetary theory starts with Wicksell’s understand of the relative interest rates. That is the quantity theory is true in the long-run but in the intermediate term and relevant for money macro equilibrium are interest rates.

Wicksell’s interest rate was:

determined by the supply and demand if no use were made of money and all lending were effected in the form of real capital goods. It comes to much the same thing to describe it as the current value of the natural rate of interest on capital.

Knut Wicksell Interest and Prices, 1898

That is why it is called the natural rate. That is in natura means something that is raw in nature and untouched. It could be called the rate of interest.

If the central bank brings the market rate of interest, in modern terms the Federal Reserve Funds rate with the hypothetical natural rate, this would replicate a world without money, a money neutrality where all prices and quantities and investor dections are based on real factors rather than monetary arbitrage. Intertemoporal descions would be coordinated optimally for investment plans.

Wicksell and the Keynesians of today (For example Michel Woodford) would equate th8is with money macro equilibrium. It would be observational through a stable price level.

The issue is the natural rate of interest is a theoretical construct and by its definition unobserved. You cannot observe a natural rate, that is a rate of interest if only barter ratios were used because money is the second half of every transaction. It is embedded so deeply in the economy that any wholly empirical estimate like the Federal Reserves R* would be nothing short of a fairy-tale. See the Fed fairy-tale here: Natural Rate of Interest.

The Interest Rate is a Price

Prices coordinated inter-temporal decision making processes. For the entrepreneur it is part of the discovery process and allows the entrepreneur to make decisions about future plans for investment. Specifically, how to length and to what extent the entrepreneur takes on long term projects. Ludwig Von Mises in 1912 in the Theory of Money and Credit outlines this.

If the price of money, or more exactly the price of loanable funds is mispriced then wrong signals are sent through the market and you have a market miscoordination.

This is so profound because money is the second half of every translation. It is everywhere so money’s non-neutral effect on the economy is like a domino that starts a process.

Federal Reserve estimates of the natural rate of interest called R-star through the FED/US model and mirrored by the DSGE model and supported by the theory of Micheal Woodford in his book Interest and Prices are rule based better than discretionary policy. However, it would be the third best way to achieve money neutrality since these estimates will consistently create bubble no matter who good the math becomes. Why? Because money is the second half of every transaction and therefore the money neutral rate is unobserved.

Market prices do something, they communicate information, they are not just some arbitrary number.

Robert Murphy

Cluster of business mistakes

If you were to wake up one morning and you heard there were 500 fender benders on U.S. Route 1 you could assume either there was temporary insanity en masse or something more likely, the traffic lights all went green. When rates are low relative to the natural rate, all lights are green.

The economy is giving false signals to the proper level of savings and investment. This results in a mis-coordination. You have a cluster of business failures. That is a business cycle. It is a distortion of the capital structure from people getting wrong signals, in this case the interest rate controlled by the Federal Reserve.

If you centrally macro manage the interest rate, you will mislead people and they will make wrong decisions.

Malinvestment – Capital Theory

A detailed discussion on the malinvestment, caused by entrepreneurs getting wrong signals is beyond the scope of this article. However, idea is understandable. When the Fed sets rates too low, relative to a money neutral level because it can not estimate correctly or there are multiple natural rate, then ex ante investment and savings is coordinated in a distorted way ex post. It is saving that there is more savings then there really is when rates are low in relation to the natural rate.

The level of investment during the boom is not supported by real savings.

Whether it is the dot com bubble or the crisis of ’08 and the expansion of real estate or the next crisis, perhaps the stock market and debt expansion crash, there is a distortion. The interest rate is giving wrong singles about how the capital lengthening process is optimal for profit.

Investing does not have anything to do with frugality and savings and real value and wealth creation, but rather a credit fueled high. This cannot be sustained as it is artificial.

Money pumping exacerbates inequality

The policy of discretionary and non-discretionary money pumping is often tied to political and business incentives and potentially exacerbates the Gini coefficient because the money flows top down to the banks and to people who have preferred.access to credit.

Austrian school of economic solutions

Let the markets work. Let saving and investment and investment coordination be determined by real market prices. This includes the elimination of the Fed and it being replaced by a market standard, rather than a PhD standard. That is people, free people make choices about saving and investment and interest rate based on real rates and prices, rather than a PhD club centrally planning the interest rate.

Keynes versus Hayek the next round

In the Keynes versus Hayek debate, new economists have entered the field.

Old Keynesians: John Maynard Keynes, John Hicks, Franco Modigliani, Paul Samuelson

New Keynesians: Michael Woodford, Paul Krugman.

Old Austrians: Ludwig von Mises, F.A. Hayek

New Austrians: George Selgin, Steven Horwitz, Robert Murphy, William Butos, Lawrence H. White

Although I would like to go into more detail, it is a good review. It is more a sketch of two schools of thought and if you have questions or please leave them in the comments below.

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