Hayek’s Austrian Theory of the Business Cycle

The essay begins with Hayek’s grappling with the equilibrium framework as a starting point for the analysis of cyclical fluctuations and the fundamental methodological challenge raised by Lowe’s attack against the construction of business-cycle theory within the system of general economic equilibrium. It then shows that Hayek elaborated his Austrian theory of the business cycle on the innovative combination of five building blocks: (1) Wicksell’s theory of the cumulative process where price changes are caused by the discrepancy between the market rate and the natural (equilibrium) rate of interest; (2) Mises’s theory of money and credit in which banks artificially lowering the money (market) rate of interest are responsible for overinvestment and a misallocation of resources which necessarily has to be corrected; (3) Böhm-Bawerk’s theory of capital with its emphasis on the time structure of the production process; (4) Cantillon effects of changes in the money supply on the price structure and hence on the structure of production (non-neutrality of money); (5) Ricardo effects of a shortage of consumption goods on the production of investment goods (disproportionality of circulating and fixed capital).