Summarizing Roger Garrison’s Austrian Business Cycle Theory Lecture

Hi everyone,

I recently finished Roger Garrison’s lecture on the Austrian Theory of the Business Cycle titled “Capital-Based Macroeconomics.” It is a roughly 50-slide presentation you can download for those who have not looked at it. It visually represents what happens when the Federal Reserve uses its policies to reduce interest rates using charts and graphs such as the Production Possibilities Frontier, Hayekian Triangle, and the Loanable Funds Market. Dr. Garrison illustrates the relationship between these charts in a regular market setting (like when people increase their savings naturally) and in a Fed-market setting (when the Fed impacts the interest rate exchanged between borrowers and savers). This post will summarize his points.

This post also functions as a sequel to my post on Austrian business cycle theory. I use spreadsheets to explain a Robinson Crusoe situation of saving, consuming, and investing and what happens when my version of the Fed gets involved in this process. That story was highly fictional, so this time, I’ll try to ground things in reality more while still being big-picture and abstract. I’ll also connect Dr. Garrison’s models and my table numbers.

A snapshot of Dr. Garrison’s PowerPoint for you all to follow along

In society, the maximum amount of spending includes investment and consumption. The 5% interest rate in the loanable funds market leads to $500 in savings in society, $750 in consumption in society, and a total spend in society of $1250. The $500 savings are immediately taken from the saving community by the business community and spent on capital goods in the early stages of production. You can see in the image above that the savings (S) are equal to the investment (D) on the loanable funds graph and the production possibilities frontier graph.

If society’s time preference decreases, the interest rate, or the price of loanable funds, decreases to 2.5%, the savings in society increase to $750, the consumption spending in society decreases to $500, and the total expenditure in society remains at $1250 because that represents the available resources in society.

And, of course, whatever the saving community saves is immediately put into spending on capital goods in the early stages of production. The workers in the early stages of production get a boost in their income, and those in the late stages experience a dip in their income.

Suppose the Federal Reserve reduces the Federal Funds Rate or engages in Open Market Operations. In that case, a lower interest rate than we had in the first table leads to unsustainable growth. The interest rate reduces from 5% to 2.5%, the savings in society decreases from 500 to 250 dollars, the consumption in society increases to $1000 from $750, and the demand for savings increases to $750 from $500 because the business community realizes they can pay a lower price than from before.

Notice how the total spending in society is $1750. This expenditure is not possible because it is beyond the available resources. The only reason the business community could spend $750 of what the saving community saved, or $500, was because it was within the “pot” of available dollars to spend. Dr. Garrison states, “…without sufficient resources being freed up elsewhere, many of these investment projects will never be completed… In fact, increased consumer demand draws some resources toward the late stages, further reducing the prospects for completing a new capital structure.” Indeed, the number of stages of production refers to the successful completion of investment activities that give rise to more capital goods in the early stages of production. If the business community needs $750 for this lengthening, and it is not available, then they need to stop spending in this area and go back to what they were doing at $500 of spending. If the consumer community is paying $1000, and what they want is unavailable, they must stop what they are doing and return to spending $750. That way, at least, the business community will have the savings they need to operate their enterprises and pay the interest on the loans to the savers accordingly.

The return to equilibrium is the unemployment faced after a boom following the Fed’s actions.

The early snapshot did not include the stage-specific labor markets in the Hayekian triangle. I’ll talk about them briefly here. The early stage of production employs a specific type of capital good that differs from the late stage—their wages change according to the spend-save attitudes of society.

Stage-specific labor markets as they react to an increase in saving

When savings increase, society pays late-stage workers less and early-stage workers more, and the employees in those organizations enter and exit the markets accordingly. If the cost of my opportunity to work another hour exceeds the wage I take, I would leave the industry I am in and go to a more suitable occupation. If I am a firm owner and receive an injection of extra funds, I could give my employees raises or spend that money hiring another employee. Nonetheless, society desired more research and development than the sales associates at that time. This process happens in real-time as we speak as tastes and preferences change, and firms accommodate those by pouring resources into what people want.

Wages increase for early- and late-stage workers when the Federal Reserve gets involved in the economy. One new employee could be added to each market and must be let go as each organization realizes they cannot pay those workers. This is unemployment and happens to many workers in these sectors when businesses get too ambitious with cheap credit. As consumption and investment spending cool, these workers leave their respective markets, and some are consumers who need to let go of their existing consumption spending.

Thanks for reading, and I hope this was helpful.