One student at LSE in the 1930s
recalls the "three-dimensional
diagrams with which Hayek
presented his ideas and which
made them seem like something
in the field of engineering."
Another LSE student noted
that Hayek wore "a thick
tweed suit with a waistcoat
and high-cut jacket." She
nicknamed him 'Mr.
Fluctooations' as he so often
used that word and
pronounced it in that way.“
-from Alan Ebenstein’s Friedrich A. Hayek: A
Biography
F. A. HAYEK
Based
on
the Theory
Sustainable
An
Application
andof
theof
Business
Cycle set
Unsustainable
Capital-Based
out by Ludwig von Mises
Growth
Macroeconomics
and
F. A. Hayek
Go To the original version of this
show, which was created in 1999.
Time
and Money
Table of Contents
Go To
Part I: The Elements of Capital-Based Macroeconomics
Go To
Part II: Integrating the Elements
Go To
Part III: Saving as a Basis for Sustainable Growth
Go To
Part IV: Legislating Low Interest Rates
Go To
Part V: Manipulating Interest Rates with Money
Go To
Part VI. Letting the Economy Grow
PART I
The Elements of
Capital-Based
Macroeconomics
Go To: Table of Contents
“Loanable funds” is the generic term that refers both to lending
(which constitutes the supply side of the market) and to
borrowing (which constitutes the demand side).
Each side of the market for loanable funds is governed by the rate
of interest.
Saving, broadly conceived, underlies the supply of loanable funds.
The Market for Loanable Funds
“Loanable funds” is the generic term that refers both to lending
(which constitutes the supply side of the market) and to
borrowing (which constitutes the demand side).
Each side of the market for loanable funds is governed by the rate
of interest.
Saving, broadly conceived, underlies the supply of loanable funds.
Borrowing by the business community constitutes the demand.
The Market for Loanable Funds
“Loanable funds” is the generic term that refers both to lending
(which constitutes the supply side of the market) and to
borrowing (which constitutes the demand side).
Each side of the market for loanable funds is governed by the rate
of interest.
Saving, broadly conceived, underlies the supply of loanable funds.
Borrowing by the business community constitutes the demand.
Therecognized
As
quantity axis
by both
measures
Eugen
von Bohm-Bawerk
saving
(and investment)
and John
as
Maynard
the
amount
Keynes,
of output
this
market is better
produced
in a given
thought
period
of
as the
and
made
market
available
for investable
for (and
resources.
actually
used
It keeps
for) the
the
macroeconomically
expansion
of the economy’s
relevant
magnitudescapacity.
productive
of saving (S) and
investment (I) in balance.
The Market for Loanable Funds
The supply price of investable resources is measured by (and
sometimes proxied by) the rate of interest. Though saving can
actually take the form of lending through banking institutions, it
can also take the form of retained earnings or the buying of bonds
or equity shares.
The demand price is similarly interpreted to include the various
ways that the business community can take command of
unconsumed output—which constitutes the investable resources.
Consumer borrowing is netted out on the supply side. That is, the
focus is on the funds lent collectively by income-earners/savers to
the business community.
In this graphical exposition,
the supply and demand for
investable funds results in a
market-clearing interest
rate of 5% with saving and
investment amounting to
$800 billion.
The Market for Loanable Funds
The supply price of investable resources is measured by (and
sometimes proxied by) the rate of interest. Though saving can
actually take the form of lending through banking institutions, it
can also take the form of retained earnings or the buying of bonds
or equity shares.
The demand price is similarly interpreted to include the various
ways that the business community can take command of
unconsumed output—which constitutes the investable resources.
Consumer borrowing is netted out on the supply side. That is, the
focus is on the funds lent collectively by income-earners/savers to
the business community.
In this graphical exposition,
the supply and demand for
investable funds results in a
market-clearing interest
rate of 5% with saving and
investment amounting to
$800 billion.
The Market for Loanable Funds
Capital-based macro features
consumption and investment
as alternative ways to use
resources.
The alternative uses are
depicted as a Production
Possibilities Frontier (PPF).
Capital-based macro features
consumption and investment
as alternative ways to use
resources.
The alternative uses are
depicted as a Production
Possibilities Frontier (PPF).
The PPF shows the maximum
sustainable level of output as
a locus of points representing
all possible combinations of
consumption and investment
for a fully employed economy.
Production Possibilities Frontier
Consider a particular point on
the frontier.
This point represents an
economy that is fully employed
(with the unemployment rate
in the 5%-6% range). Hence,
output is being produced at a
sustainable rate.
Production Possibilities Frontier
Consider a particular point on
the frontier.
This point represents an
economy that is fully employed
(with the unemployment rate
in the 5%-6% range). Hence,
output is being produced at a
sustainable rate.
Now consider a disequilibrium
point inside the PPF.
This point represents an
economy in recession,
producing fewer consumption
goods and/or fewer
investment goods than it
could.
Production Possibilities Frontier
The distance below the
frontier reflects the idleness
of labor and other resources.
The unemployment rate is
higher than 6%, suggesting
significant cyclical
unemployment.
Now consider a disequilibrium
point beyond the PPF.
This point represents an
overheated economy. The
unemployment rate is below
5%. The level of output is
unsustainable. (Points very
far beyond the PPF are, of
course, literally impossible.
Production Possibilities Frontier
The second P in PPF suggests
that it is actually possible for
the economy to move along
the frontier—a possibility
denied by Keynes with his
paradox of thrift.
Increased saving moves the
economy along the PPF in the
direction of more investment;
decreased saving moves the
economy along the PPF in the
direction of consumption.
Investment in this framework
is measured in gross terms.
Suppose an investment of
$600 billion is needed just to
offset depreciation.
DEPRECIATION = $600
As long as gross investment is
greater than depreciation, the
economy will grow, as will be
represented by an outward
shift in the PPF itself.
CONSUMABLE OUTPUT
PRODUCTION TIME
Beyond the two-way division
of resource usage captured by
the PPF, capital-based macro
tracks the intertemporal
allocation of investable
resources.
Production time is measured
along the horizontal axis.
The vertical axis tracks the
value dimension—with value
at the end of the production
process representing
consumable output.
Hayek conceived of a number
of distinct stages of
production, the output of
each feeding into the next as
input.
Each stage, then, has its own
time dimension and value
dimension. A stage’s value
dimension reflects the
discounted value of the future
consumable output.
CONSUMABLE OUTPUT
RETAILING
DISTRIBUTIING
MANUFACTURING
REFINING
MINING
STAGES OF
PRODUCTION
At a given point in time, an
ongoing production process is
characterized by activities in
all the separate stages.
Dividing the economy’s
Production process into five
stages is a matter of
pedagogical convenience.
Identifying the stages as
“mining” through “retailing”
is only suggestive. The actual
intertemporal structure of
capital, of course, entails a
complexity of interconnected
production activities.
CONSUMABLE OUTPUT
STAGES OF PRODUCTION
For analytical purposes, the
economy’s production process
is conceived as a continuum of
stages and is represented as
goods in the making that gain
value as they near completion.
The resulting figure is known as
the Hayekian triangle.
Strictly speaking, the triangle
constrains the production
process to a particular type:
continuous-input/point-output.
The “value added” at each stage
consists of two components:
(1) the adding of further
inputs and
(2) the movement in time
towards the ultimate yield of
consumable output.
C
The Hayekian Triangle, then,
has two mutually reinforcing
interpretations.
First, it depicts the production
process that plays itself out
over time.
PRODUCTION TIME
While at each point in time
there are goods in the making
at each stage, the economy’s
ultimate output can be
identified with a temporal
sequence of activities.
Watch the goods in progress
move through the stages.
Second, it depicts the full
complement of stages that
exist at a given point in time.
This second interpretation
suggests that resources can be
reallocated in either direction
from one stage to another.
Reallocation among the stages
will affect the temporal pattern
of consumable output
PART II
Integrating the
Elements
Go To: Table of Contents
The market for loanablefunds—a.k.a. investable
resources—shows that the
market-clearing rate of
interest is 5%, at which
saving and investment are
in equilibrium at $800
billion.
The market for loanablefunds—a.k.a. investable
resources—shows that the
market-clearing rate of
interest is 5%, at which
saving and investment are
in equilibrium at $800
billion.
The PPF shows that with
$800 billion committed to
investment activities, $2200
billion are available for
current consumption.
The market for loanablefunds—a.k.a. investable
resources—shows that the
market-clearing rate of
interest is 5%, at which
saving and investment are
in equilibrium at $800
billion.
An
The
The
initial
Hayekian
slopefull-employment
of the
triangle
hypotenuse
depicts
current
equilibrium
of the Hayekian
consumption
is defined
triangle
as
by:
the
output
reflectsofathe
rateeconomy’s
of interest
the Loanable-Funds Market,
multi-stage
consistent with
production
the rate that
process.
the
prevails
PPF, in
The
the
rate
loanableof interest
governs
funds
market.
the allocation
of
the
Hayekian
Triangle,...
resources among the stages.
…plus the representative
stage-specific labor markets.
$600
If gross investment needed to
offset capital depreciation is
$600 billion, the economy is
experiencing net investment
of $200 billion.
$600
The increase
This
additional
in capital
productive
is
distributed
capacity
and
among
hencethe
in output
stages
of depicted
is
production
by in
a shifting
accordance
with an unchanged
outward
of the PPF rate
and by
of a
interest.
corresponding
shifting of the
supply and demand for
loanable funds.
Watch the economy grow!
Watch the economy grow!
Watch the economy grow!
Watch the economy grow!
To
With
Wethe
turn
gross
extent
next
investment
that
to the
increased
effect of
greater
incomes
increased
than
and
saving,
capital
wealth
whatever
reduce
depreciation,
the
thepremium
underlying
on
the
cause
current
economy
of the
experiences
consumption
increase. secular
and increase
growth.
This rate
saving
propensities,
of growth isthe
sustainable.
economy
will grow faster.
PART III
Saving as a Basis
for Sustainable
Economic Growth
Go To: Table of Contents
The supply of loanable funds registers people’s current saving
preferences. Changes in saving behavior for the economy as a
whole can stem from a change in demographics or from a
change in attitudes toward saving. People may become more
conscious of the need to save for their children’s education or
for their retirement years.
Suppose that, for whatever reason, people decide to save more.
The supply of loanable funds registers people’s current saving
preferences. Changes in saving behavior for the economy as a
whole can stem from a change in demographics or from a
change in attitudes toward saving. People may become more
conscious of the need to save for their children’s education or
for their retirement years.
Suppose that, for whatever reason, people decide to save more.
The supply of loanable funds
shifts to the right, registering
the increased inclination to
save, or equivalently, the
decrease in time preferences.
The interest rate falls from
5% to 2.3%, encouraging the
business community to
increase investment from
$800 billion to $1000 billion.
The supply of loanable funds registers people’s current saving
preferences. Changes in saving behavior for the economy as a
whole can stem from a change in demographics or from a
change in attitudes toward saving. People may become more
conscious of the need to save for their children’s education or
for their retirement years.
Suppose that, for whatever reason, people decide to save more.
The loanable funds market
strikes a new equilibrium.
Both saving and investment
increase to $1,000 billion.
The PPF shows how the
increased saving affects the
mix of consumption and
investment.
For a given income, saving
more means consuming less.
The PPF shows how the
increased saving affects the
mix of consumption and
investment.
For a given income, saving
more means consuming less.
The economy moves along
the frontier, as current
consumption is reduced from
$2,200 billion to $1,780
billion.
Resources are shifted away
from production activities
aimed at the present and
near-future and toward
production activities aimed
at the more remote future.
A reshaping of the Hayekian
triangle mirrors the movement along the PPF in the
direction of investment and
depicts the change in the
time dimension in the
production process.
With
In the
reduced
early stages,
consumption
demand
demand,
for labor the
andderived
other factors
demand
of
for
production
labor andisother
increased,
factors
asof
production
the interest-rate
in the effect
late stages
moreis
than-offsets
reduced as the
well.
deriveddemand effect .
A wage-rate differential during the capital restructuring
encourages workers to move from late stages to early stages.
A wage-rate differential during the capital restructuring
encourages workers to move from late stages to early stages.
Watch the economy respond to an increase in saving.
Watch the economy respond to an increase in saving.
Early-stage
A
People
saving-induced
don’tinvestments
just save;
reallocation
they
of resources
save-up-for-something.
during
this transition
among the
allow
stages
Consumption
the
increased
of production
is
future
downskews
only
the pattern
temporarily—during
demands
forofconsumption
consumable
the
watch
outputto
transition
goods
toward
be
toaccommodated.
new
thegrowth
future.
path.
The
economy
grows more
the
economy
grow!
rapidly than before.
Now
Now watch
the economy grow!
Now watch
the economy grow!
Now watch
the economy grow!
Saving & Growth
An initial increase in saving,
attributable to a change in
intertemporal consumption
preferences, is depicted by a
movement along the PPF.
The increase investment made possible by this initial saving
allows PPF to shift outward in larger increments than before the
change in intertemporal preferences.
PART IV
Legislating
Low Interest Rates
Go To: Table of Contents
Accelerated growth driven by an increase in saving entails a
market process in which the interest rate falls and investment
increases.
Policymakers may misunderstand the nature of the process and
believe that low interest rates (rather than increased saving) is
the cause of the increased growth rate.
With this understanding in mind,
Congress might enact an
interest-rate ceiling, prohibiting
a yield of more than, say, 2.3%
on financial assets.
Accelerated growth driven by an increase in saving entails a
market process in which the interest rate falls and investment
increases.
Policymakers may misunderstand the nature of the process and
believe that low interest rates (rather than increased saving) is
the cause of the increased growth rate.
With this understanding in mind,
Congress might enact an
interest-rate ceiling, prohibiting
a yield of more than, say, 2.3%
on financial assets.
The result would be a credit
shortage, which would be
apparent as soon as the
legislation went into effect.
Accelerated growth driven by an increase in saving entails a
market process in which the interest rate falls and investment
increases.
Policymakers may misunderstand the nature of the process and
believe that low interest rates (rather than increased saving) is
the cause of the increased growth rate.
With this understanding in mind,
Congress might enact an
interest-rate ceiling, prohibiting
a yield of more than, say, 2.3%
on financial assets.
The result would be a credit
shortage, which would be
apparent as soon as the
legislation went into effect.
Accelerated growth driven by an increase in saving entails a
market process in which the interest rate falls and investment
increases.
Policymakers may misunderstand the nature of the process and
believe that low interest rates (rather than increased saving) is
the cause of the increased growth rate.
With this understanding in mind,
Congress might enact an
interest-rate ceiling, prohibiting
a yield of more than, say, 2.3%
on financial assets.
The result would be a credit
shortage, which would be
apparent as soon as the
legislation went into effect.
Accelerated growth driven by an increase in saving entails a
market process in which the interest rate falls and investment
increases.
Policymakers may misunderstand the nature of the process and
believe that low interest rates (rather than increased saving) is
the cause of the increased growth rate.
With this understanding in mind,
Congress might enact an
interest-rate ceiling, prohibiting
a yield of more than, say, 2.3%
on financial assets.
With the yield on financial
assets held to 2.3%, the
yield on real assets would
rise to 7.7%, as indicated by
the demand price.
Accelerated growth driven by an increase in saving entails a
market process in which the interest rate falls and investment
increases.
Policymakers may misunderstand the nature of the process and
believe that low interest rates (rather than increased saving) is
the cause of the increased growth rate.
With this understanding in mind,
Congress might enact an
interest-rate ceiling, prohibiting
a yield of more than, say, 2.3%
on financial assets.
With the yield on financial
assets held to 2.3%, the
yield on real assets would
rise to 7.7%, as indicated by
the demand price.
In the face of diminished
incentives to save, people
begin consuming more.
Foiled by the interest-rate
ceiling, people increase their
consumption to $2,480 billion,
moving the economy
counterclockwise along the
PPF.
In the face of diminished
incentives to save, people
begin consuming more.
Foiled by the interest-rate
ceiling, people increase their
consumption to $2,480 billion,
moving the economy
counterclockwise along the
PPF.
There is now a premium on
producing for the present.
Labor and other resources are
bid away from early stages of
production and into late
stages. The value added at
each stage reflects the yield
on real assets of 7.7%.
There is now a premium on
producing for the present.
Labor and other resources are
bid away from early stages of
production and into late
stages. The value added at
each stage reflects the yield
on real assets of 7.7%.
The market-clearing wage
rate for late-stage labor will
be higher than the marketclearing wage rate for earlystage labor during the period
that the intertemporal capital
structure is adjusting to the
credit ceiling.
Now, watch the economy react to a credit ceiling.
Now, watch the economy react to a credit ceiling.
PART V
Manipulating
Interest Rates
with Money
Go To: Table of Contents
A lower interest rate imposed
on the market by direct
legislation has a negative
effect—and one that becomes
apparent almost immediately.
A seemingly positive effect—
though only a temporary
one—can be achieved if the
interest rate is lowered not by
an act of Congress but rather
by an act of the central bank.
A lower interest rate imposed
on the market by direct
legislation has a negative
effect—and one that becomes
apparent almost immediately.
A seemingly positive effect—
though only a temporary
one—can be achieved if the
interest rate is lowered not by
an act of Congress but rather
by an act of the central bank.
A lower interest rate imposed
on the market by direct
legislation has a negative
effect—and one that becomes
apparent almost immediately.
A seemingly positive effect—
though only a temporary
one—can be achieved if the
interest rate is lowered not by
an act of Congress but rather
by an act of the central bank.
The Federal Reserve can
increase the money supply
by lending into existence an
additional quantity of
money.
Injecting money so as to
drive the interest rate down
to 2.3% is equivalent—at
least in its initial effects—to
imposing an interest-rate
ceiling of 2.3% and then
“papering over the credit
shortage” with newly
created money.
Padding the supply of loanable
funds with new money drives
a wedge between saving and
investment.
The easy-money policy
obscures the resulting
reduction in saving while it
spurs on investment activities
with a ready supply of credit
at a low rate of interest.
Whereas the problems of an
interest-rate ceiling are
immediately apparent, the
problems of a credit
expansion are pushed into the
future—and are allowed to
fester until they eventually do
become apparent.
The conflicting market forces
pit consumers against
investors in a tug-of-war.
The conflicting market forces
pit consumers against
investors in a tug-of-war.
With less saving and more
spending, the behavior of
consumers is consistent with a
counterclockwise movement
along the PPF. But with
production decisions governed
by a low interest rate, the
behavior of investors is
consistent with a clockwise
movement along the PPF.
The conflicting market forces
pit consumers against
investors in a tug-of-war.
Together, consumers and
investors push the economy
beyond its PPF.
The policy-induced
combination of consumption
and investment is
unsustainable….
The conflicting market forces
pit consumers against
investors in a tug-of-war.
Together, consumers and
investors push the economy
beyond its PPF.
The policy-induced
combination of consumption
and investment is
unsustainable….
…but politically popular.
The conflicting market forces
pit consumers against
investors in a tug-of-war.
Together, consumers and
investors push the economy
beyond its PPF.
The policy-induced
combination of consumption
and investment is
unsustainable….
…but politically popular.
Excessively long-term projects
are initiated at the same time
that consumer demand is
unusually high.
The “wedge” and “tug-of-war”
translate into a distortion of
the structure of production.
Excessively long-term projects
are initiated at the same time
that consumer demand is
unusually high.
The “wedge” and “tug-of-war”
translate into a distortion of
the structure of production.
The resources
Hayekian triangle
committed
is being
to
pulled
the
early
at both
stages
ends
of production
against
the middle.“malinvestment.”
constitute
The market
process is set against itself as
At the same time, other
investors and consumers
resources are allocated to the
respond in their own way to a
late stages in response to the
low rate of interest.
“overconsumption.”
The
specific
supply
of
course
loanable
of the
funds
For
a time,
increased
Further,
changes
in the
boom-bust
can
be affected
cycle
by
beyond
increased
the
consumption
and
increased
structure of production
reflect
initial
liquidity
malinvestment
preference
and
and
the
investment
have their
capital durability
and
overconsumption
consequent
building
is not
up
of
wholly
separate
effects.
The
economy
specificity
and the
particular
determinate.
monetary
hoards
The
and
demand
by the
for
moves
the
PPF,
patternbeyond
of complementarities
loanable
actions
offunds
the
can be Reserve
affected
producing
an Federal
unsustainable
and substitutabilities.
by
aimed
distress
atoutput.
mitigating
borrowing
the
and/or
level
of
a loss of business confidence.
downturn.
There
The
tug-of-war
lacking
is an investment
of capital
between
and
bias in
the allocation
consumption
other
resources
and
of resources,
investment
however—as
is
complementary
partially won
theby
to
business
those
the
community
investment,
already
committed
tries
if only
to because
to
take
the it
advantage
has
production
more “pull”—the
of
process
the artificially
eventually
new
low rate
money
brings
the
being
ofboom
interest
lentto an
andend
at the
and
same time
predominantly
returns
thesatisfy
economy
to businesses.
increased
to its
consumer demand.
PPF.
The subsequent
initial movement
reduction
of the
in
economy beyond
consumption
made
the
necessary
PPF
constitutes
by
the overcommitment
overconsumption
of
(the upward
resources
to long-term
movement) and
overinvestment
investment
projects
(the
rightward movement).
constitutes
“forced saving.”
In this
The
discoordination
phase of the cycle,
of the a
economyof
collapse
characteristic
the money supply
of a
policy-induced
can
give leverage
boom-bust
to the
cycle sets themaking
contraction,
stage for
thea
secondary contraction—a
depression
much deeper than
spiraling
can
be accounted
of the economy
for solely
to in
some point
terms
of theinside
prior the PPF.
misallocation of resources.
Watch the economy
respond to an injection of
money through credit
markets!
Watch the economy
respond to an injection of
money through credit
markets!
PART VI
Letting the
Economy Grow
Go To: Table of Contents
Don’t grow the economy.
Just let the economy grow.
Don’t grow the economy.
Just let the economy grow.
Don’t grow the economy.
Just let the economy grow.
Don’t grow the economy.
Just let the economy grow.
Don’t grow the economy.
Just let the economy grow.
Don’t grow the economy.
Just let the economy grow.
Go To: Table of Contents
E-mail R. W. Garrison
“Booms have always appeared with
a great increase in investment, a
large part of which proved to be
erroneous, mistaken. That, of
course, suggests that a supply of
capital was made apparent which
wasn’t actually existing. The whole
combination of a stimulus to invest
on a large scale followed by a
period of acute scarcity of capital is
consistent with the idea that there
has been a misdirection due to
monetary influences.
And that general schema, I still
believe (circa 1978), is correct.”
-paraphrased from an interview conducted by Jack High as
part of the UCLA Oral History Program (1978).
F. A. HAYEK
Time and Money: The Macroeconomics of Capital Structure
London: Routledge, 2001.
Time and Money develops and
defends this capital-based
macroeconomic framework and
compares it to the alternative
frameworks associated with
Keynesianism and Monetarism.
Going beyond the issues of growth
and cyclical variation, the book also
deals with deficit spending, credit
controls, tax reform, and more.
Excerpts from the book plus some
supplementary material can be found
at http://www. auburn.edu/~garriro
F. A. HAYEK