The real story behind the phenomena of booms and busts

February 8th, 2007

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Today, we will explain how the business cycle of booms and bust comes about. If you have not already read What cause booms and busts? Introduction to the Austrian Business Cycle Theory followed by What cause booms and busts? Explanation of Austrian Business Cycle Theory metaphor, please do so because what comes next will not make sense without the background understanding of these two articles.

First, we revisit the thought-provoking question that we first asked in What cause booms and busts? Introduction to the Austrian Business Cycle Theory: How can the central bank know the ?right? price of money when it decides the level of interest rates? The truth is, it does not and the outcome is less than ideal as it sets interest rates at levels other than ones the free market would have chosen.

Let us suppose that interest rates are decided by market forces. How would it be decided? As expected, the fundamental economic law of supply and demand determines the level of interest rates. As consumers seek to defer their consumption to the future, they increase their savings rate. This increase in the supply of money from savings pushes down the interest rates. Conversely, as consumers seek to increase their current consumption at the expense of the future, they decrease their savings rate, which decrease the supply of money for savings, which in turn pushes up interest rates. On the side of the entrepreneurs, their demand of capital, which is supplied from the consumers’ savings, will lead to an equilibrium level where supply equals demand. This equilibrium level is the natural rate of interests.

Now, what happens if the central bank interferes with market forces and set the interest rates below the natural rate? The outcome would be that the demand for capital (from entrepreneurs) will exceed the supply of capital (from consumers). The only way to bridge this gap would be to increase the supply of money (that is, ‘printing’ of money). When that happens, through the fractional reserve banking system, the amount of credit in the financial system will be increased multi-fold. Consumers will spend more than they would have if the interest rates had been higher. Entrepreneurs would invest more than they would have if the interest rates had been higher. The outcome would be ‘greater’ economic activity.

But there is one problem with this state of affairs?there are finite amount of resources for the economy to work on in order to keep up the rate of production with the increased investment and consumer demands. Thus, for a time, the economy can be stressed to increase its rate of production, but ultimately, it will meet its limit. At this point in time, the boom part of the business cycle is coming to a halt. This is what is happening to Australia right now as the Reserve Bank increasingly uses the phrase “capacity constraint” to describe the economic situation.

If the interest rates are still kept artificially below the natural rate, the outcome will be price inflation as the artificially induced demand far outstrips the economy’s capacity to produce. If left unchecked, the result will be hyperinflation. Thus, the central bank will have to raise interest rates to curb the excess demand. Consumers will cut their consumption as their debt becomes more expensive. Entrepreneurs will slow down their rate of investments, which means that employees will be laid off, projects cancelled, and cost being cut. At this point, we have come to the bust part of the business cycle.

Thus, the adjustment of interest rates by the central bank does not ?smooth out? the peaks and troughs of the business cycle. Instead, such interference of the interest rates is the cause of the business cycle.

Now, where are we in the business cycle?

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