Hayek's Austrian Theory of the Business Cycle

The essay begins with Hayek's grappling with the equilibrium framework as the 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).