Reply To: Business Cycle Questions


1. The price of every asset rises when interest rates fall because the price of an asset is the sum of the DMRP it generates in productive use each period over its useful lifespan. The discount (D) of the future stream of MRP is the rate of interest. A lower rate of interest means a smaller discount and therefore a larger sum of DMRPs.

2. Any production process of a consumer good consists of all steps from extracting natural resources to producing each intermediate capital good to eventually producing the consumer good. To lengthen a production process means that it takes more time to complete all the steps. Lengthening, then, is only justified when people’s time preferences decline, i.e., people are willing to wait longer to obtain the consumer good. Lengthening the capital structure involves diverting resources from lower stages to higher stages of production.

3a. Preferences that people have for a good determine both the position of demand and and the position of supply in the market. Supply and demand in turn determine both the amount of the good traded and its price. In the same way, time preferences determine both the position of the demand for and the position of the supply of present money in exchange for future money. Supply and demand in turn determine both the extent of saving-investing and the rate of interest. Credit expansion does not change people’s time preferences (i.e., it does not shift people’s demand for or supply of present money), it merely adds a artificial source of supply of present money to the supply people prefer. The extra supply of present money shifts the total supply to the right which suppresses interest rates. The lower interest rates in turn lower people’s quantity supplied of present money (they move down and to the left on their given supply curve) and raises people’s quantity demand for money (they move down and to the right on their given demand curve). But time preferences, which position both the supply and demand curves do not change. The artificial supply of present money through credit expansion drives a wedge between people’s genuine saving, which is now smaller, and people’s investment expenditures, which are now larger.

3b. The reason why profits concentrate in particular lines is that the borrowed money from credit expansion is spent to buy assets in particular lines of production and not in other lines. For example, cheap mortgage money is borrowed to buy houses and so prices of houses and prices of specific producer goods used to build houses rise relative to the prices of apples and the specific producer goods used to produce apples. This is what we called the “specific effect” of credit expansion.

4. The crack up boom only occurs when the central bank continues to relentlessly inflate the money stock through credit creation even in the face of rising prices all around. Thankfully, this is rather uncommon historically. Interest rates always rise as a feature of correcting the financial excesses of the boom. The interest rate is not just contract interest paid on loans, but is the spread between output prices and input prices in all production. As credit expansion occurs during the boom suppressing contract interest rates on loans, entrepreneurs begin to borrow cheap credit to buy assets leading to asset price inflation which squeezes price spreads. When the financial crisis hits, asset-price bubbles burst helping to restore price spreads to those consistent with people’s time preferences.

You might take a look at the article by Joe Salerno: