Hayek The Theory Of Business Cycles

F. A. Hayek and The Theory Of Business Cycles

Mises' theory of money and credit led to an Austrian theory of business cycles based upon changes in the supply of money, a theory elaborated most completely by one of Mises' students, Nobel laureate Friedrich A. Hayek. Like Mises, Hayek broke with the quantity theory tradition because it ignored the effect of money on relative prices. He continued the integration of monetary theory and value theory that Mises had begun by exploring the effect of changes in the supply of money on the composition of output, rather than upon the quantity of output or the aggregate price level.

Hayek's business-cycle theory is a blend of the Austrian theories of money, cap­ital, and prices. In a nutshell, his explanation of the cycle runs like this. A monetary disturbance (e.g., an increase in the money stock) brings about a reduction of inter­est rates below an equilibrium level, which stimulates investment in capital, thereby reallocating resources away from the production of consumption goods toward pro­duction of intermediate (capital) goods. As a consequence, prices of capital goods rise and prices of consumption goods fall. This change in relative prices changes the structure of production. (Hayek viewed the entire process of production as a multi-stage activity through which raw materials pass until they finally emerge as end prod-ucts. Therefore, a change in the number of stages or a reallocation of resources among the different stages constitutes a change in the structure of production ) Such a change in the structure of production, because of the longer time component of cap­ital, leads to overinvestment in "longer" or more "roundabout" methods of produc­tion and thereby upsets the coordination of plans between consumers and producers and between savers and investors.

Although Hayek's chief technical contribution to economic theory was his mon­etary theory, his important conception of equilibrium as the coordination of economic activities became the unifying theme in all of his writings. Coordination is achieved when the plans of all economic decision makers mesh. How does this come about? Decision makers look for signals. The appropriate signals are relative prices. Hayek argued that if relative prices change due to the "natural" forces of technology, tastes, time preference, etc., the ensuing adjustments will reestablish a coordinated plan. But purely monetary disturbances evoke perverse signals by artificially raising rates of return on certain types of economic activity. These rates of return can only be sus­tained as long as additional monetary stimulus is forthcoming, so eventually every boom will be followed by a bust.

Hayek centered his business cycle theory on the market signals utilized by savers and investors to make their decisions. He emphasized that although these decisions are independently arrived at, they are interdependent in terms of their implications for equilibrium. Cycles occur when a general inconsistency of plans comes about. In the case of a monetary stimulus, firms tend to switch to more capital-intensive methods at the expense of consumption-goods production, despite the fact than no additional planned savings has taken place. According to Hayek:

[T]his sacrifice is not voluntary, and is not made by those who will reap the benefit from the new investments. It is made by the consumers in general who, because of the increased com­petition from the entrepreneurs who have received the additional money, are forced to forego part of what they used to consume. It comes about not because they want to consume less, but because they get less goods for their money income. There can be no doubt that, if their money receipts should rise again, they would immediately attempt to expand consumption to the usual proportion (Prices and Production, p. 57).

Hayek completed his research on monetary theory and business-cycle theory in the 1930s, at a time when Keynesian macroeconomics was on the ascendancy. Even­tually his monetary theory was eclipsed by the so-called Keynesian revolution. In more recent times, Hayek has turned his attention to other important analytical is­sues, especially, the role of information in economic activity. This latter contribu­tion has shown a greater survival value than Hayek's earlier one, and Hayek has been timely in anticipating a revival and reformulation of contemporary theories of com­petition. Particularly the ideas of knowledge, information, and transactions cost. While present space and organizational structure impede a complete discussion of Hayek's contribution to this literature, his pioneer efforts have had a major influence on the development of contemporary economic thought.