Garrison’s Model of Austrian Macroeconomics

Garrison’s Model Garrison’s Model of Austrian of Austrian

MacroeconomicsMacroeconomicsIntermediate MacroeconomicsIntermediate Macroeconomics

ECON-305 Fall 2013ECON-305 Fall 2013Professor DaltonProfessor Dalton

Boise State UniversityBoise State University

Distinguishing BeliefsDistinguishing Beliefs

1.1. Expectations are forward-looking but Expectations are forward-looking but each individual agent possesses each individual agent possesses unique, diverse and partial unique, diverse and partial knowledge-information sets; knowledge-information sets; coordination failures are possiblecoordination failures are possible

2.2. Economy has a tendency towards Economy has a tendency towards intertemporal equilibrium output and intertemporal equilibrium output and employment through entrepreneurial employment through entrepreneurial adjustments to relative pricesadjustments to relative prices

Distinguishing BeliefsDistinguishing Beliefs

3.3. Cantillon effects assures non-Cantillon effects assures non-neutrality of money in short and neutrality of money in short and long runlong run

4.4. Discretionary fiscal and monetary Discretionary fiscal and monetary policy increase uncertainty and policy increase uncertainty and increase likelihood of coordination increase likelihood of coordination problems; rules are preferable to problems; rules are preferable to discretion and automatic institutions discretion and automatic institutions are preferable to rules.are preferable to rules.

Capital-Based MacroeconomicsBased on the Business Cycle Theory of Ludwig von Mises and F. A. Hayek

With acknowledgment to Professor Roger W. Garrison, Auburn University

“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

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. The demand for loanable funds represents demand by businesses for investment.

Production Possibilities Frontier

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.

Capital-based macro features consumption and investment as alternative ways to use resources.

The alternative uses are depicted as a Production Possibilities Frontier (PPF).


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. The distance below the frontier reflects the idleness of labor and other resources. The unemployment rate is higher than 6%, suggesting significant cyclical unemployment.


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.)

Now consider a disequilibrium point beyond the PPF.

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.

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.

Investment in this framework is measured in gross terms. Suppose an investment of $600 billion is needed just to offset depreciation.

DEPRECIATION = $600

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.

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At a given point in time, an ongoing production process is characterized by activities in all the separate stages.

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STAGES OF PRODUCTION 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.

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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.

First, it depicts the production process that plays itself out over time.

Second, it depicts the full complement of stages that exist at a given point in time; the second interpretation suggests that resources can be reallocated in either direction from one stage to another.

The market for loanable-funds—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 loanable-funds—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 Hayekian triangle depicts current consumption as the output of the economy’s multi-stage production process. The rate of interest governs the allocation of resources among the stages.

The slope of the hypotenuse of the Hayekian triangle reflects a rate of interest consistent with the rate that prevails in the loanable- funds market.

An initial full-employment equilibrium is defined by:

the Loanable-Funds Market,the PPF,

the Hayekian Triangle,...

…plus the representative stage-specific labor markets.

If gross investment needed to offset capital depreciation is $600 billion, the economy is experiencing net investment of $200 billion.

$600

$600

The increase in productive capacity and hence in output is depicted by a shifting outward of the PPF and by a corresponding shifting of the supply and demand for loanable funds.

This additional capital is distributed among the stages of production in accordance with an unchanged rate of interest.

$600

Watch the economy grow!

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.

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 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.

The PPF shows how the increased saving affects the mix of consumption and investment.

For a given income, saving more means consuming less.

A reshaping of the Hayekian triangle mirrors the move-ment along the PPF in the direction of investment and depicts the change in the time dimension in the production process.

With reduced consumption demand, the derived demand for labor and other factors of production in the late stages is reduced as well.

In the early stages, demand for labor and other factors of production is increased, as the interest-rate effect more-than-offsets the derived-demand effect .

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.

A saving-induced reallocation of resources among the stages of production skews the pattern of consumable output toward the future.

Early-stage investments during this transition allow the increased future demands for consumption goods to be accommodated. The economy grows more rapidly than before.

People don’t just save; they save-up-for-something. Consumption is down only temporarily—during the transition to new growth path.

Now watch the economy grow!

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.




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 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.

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.

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 market-clearing wage rate for early-stage labor during the period that the intertemporal capital structure is adjusting to the credit ceiling.

Now, watch the economy react to a credit ceiling.

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.

Together, consumers and investors push the economy beyond its PPF.

The conflicting market forces pit consumers against investors in a tug-of-war.

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.


…regardless of party.

The conflicting market forces pit consumers against investors in a tug-of-war.Together, consumers and investors push the economy beyond its PPF.


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 Hayekian triangle is being pulled at both ends against the middle. The market process is set against itself as investors and consumers respond in their own way to a low rate of interest.

The resources committed to the early stages of production constitute “malinvestment.”

At the same time, other resources are allocated to the late stages in response to the “overconsumption.”

For a time, increased consumption and increased investment have their separate effects. The economy moves beyond the PPF, producing an unsustainable level of output.

The tug-of-war between consumption and investment is partially won by the investment, if only because it has more “pull”—the new money being lent predominantly to businesses.

There is an investment bias in the allocation of resources, however—as the business community tries to take advantage of the artificially low rate of interest and at the same time satisfy increased consumer demand.

The initial movement of the economy beyond the PPF constitutes overconsumption (the upward movement) and overinvestment (the rightward movement).

But this is unsustainable, and the next phase of the cycle will be a movement back toward the sustainable PPF.

In this phase of the cycle, a collapse of the money supply can give leverage to the contraction, making the depression much deeper than can be accounted for solely in terms of the prior misallocation of resources.

The discoordination of the economy characteristic of a policy-induced boom-bust cycle sets the stage for a secondary contraction—a spiraling of the economy to some point inside the PPF.

Watch the economy respond to an injection of money through credit markets!

Common ConfusionsCommon Confusions

For simplicity, the model that has For simplicity, the model that has been produced shows a reduction in been produced shows a reduction in the interest rate causing an the interest rate causing an unsustainable boom.unsustainable boom.

However, all that is needed to However, all that is needed to initiate an unsustainable boom is initiate an unsustainable boom is that the actual interest rate be that the actual interest rate be below the natural interest rate.below the natural interest rate.

Common ConfusionsCommon Confusions During an investment boom initiated During an investment boom initiated

by changes in technology, one would by changes in technology, one would expect the demand for loanable funds expect the demand for loanable funds to rise relative to the supply of to rise relative to the supply of savings. This should cause the savings. This should cause the interest rate to rise.interest rate to rise.

If the central bank steps in to If the central bank steps in to moderate interest rates, the interest moderate interest rates, the interest rate might stay the same or rise but rate might stay the same or rise but still be below the natural rate.still be below the natural rate.

Roger Garrison, Time and Money: The Macroeconomics of Capital Structure, London: Routledge, 2001.

F. A. HAYEK

Excerpts from the book plus some supplementary material can be found at http://www. auburn.edu/~garriro

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.

Garrison’s Model of Austrian Macroeconomics

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