Government 1B Week 8 Austrian Theory of the Business Cycle

Question 1: Explain the basics of the Austrian theory of the business cycle. What is the difference, in terms of consequences, between lower interest rates that result from saving choices of individuals, and lower interest rates that are obtained artificially, by a government established central bank.

In a natural, undisturbed economy people deposit money into the central bank in order to save more for the future. This excess of funds allows banks to naturally lower their interest rates, which in turn convinces business firms to take out loans to fund their long term projects. Each bank wants the majority of business firms to come to them for loans, so they lower the interest rates more in order to compete. Now, since people are saving their present money they intend to spend it in the future. The business firms are also spending their loans on projects that will make them more productive in the future. In the mean time, people aren’t spending as much, which means the economy doesn’t need to produce as much. Since the economy doesn’t need to produce as much, the resources that were being used to make products can now be used by the business firms in building their long term projects.

People are saving money for the future, and business’s can obtain both the funds and materials necessary to produce more in the future. Everyone wins, that is until government tries to artificially lower interest rates. When the government tries this the whole system falls outta wack. The public is not saving more, which means they are consuming the same amount as always. They continue to consume, and the business’s have to use the resources to make products instead of use it to build their long term projects.

So through the artificially lowered interest rates the business’s are being mislead to start projects that they don’t have the resources necessary to complete. They waste their time and money, as well as waste many other peoples time and money by fighting for resources they have no way to obtain. The result of artificially lowered interest rates is economical conflict. Labor and physical resources become misallocated, and business’s are tricked into pushing forward projects that in the end will be financially and physically impossible to complete. This is why we’ve seen random drops in our economy throughout the years. It’s not simply because capitalism is flawed, as hypothesized by Marx. But rather the governments impatience and greed.