Reply To: Higher interest rates causing the bust


The capital value of an asset is the present value of future revenues it generates. The present value is found by discounting the future revenue by the rate of interest. So a higher interest rate reduces the present value of an asset.

The lower interest rate during the boom makes lengthening out the production structure more profitable. Once it has been lengthened out, then higher interest rates make shortening the production structure profitable. For example, during the boom, the increased demand for iron makes expanding the capital capacity in mining equipment more profitable. Iron producers increase their capital capacity. When the bust comes, the demand for iron dries up and the capital value of the capital capacity declines. Part of the investment of the boom proves to be mal-investment.