Business Cycle Questions

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    Professor Herbener,

    In “The Business Cycle, Part I”, I have a few questions regarding the ABCT.

    1) On #2, in the boom phase, you talked about the “general effect”, where the price of the durable good is the sum of the DMRP. To be clear, the price would rise due to entrepreneurs borrowing money at lower interest rates? I was a little confused on this part.

    2) On #4, you talked about the capital structure. Can you explain a little bit more about the lengthening of the capital structure? In your automobile example, you talked about iron, and how it was needed to build more factories and cars. So does the lengthening of the capital structure mean that more resources need to be diverted to more projects before the final good can be produced?

    3) a. On #5, you talked about time preference. I understand that people’s time preference, originary interest as Mises called it, regulated how resources are allocated inter-temporally, but can you explain a little more on how it doesn’t satisfy people’s time preference? I understand that the injection of credit would make it look like people have more money in investments, but since that has occurred, and the interest rates are lowered, wouldn’t people’s time preference be higher since the interest rates are lower (people not save as much proportionately and borrow more)?

    b. You talked about how profits are concentrated in certain lines. Can you go a little more in-depth with this? How does this happen exactly? Why aren’t there profits in every line of durable goods manufacturing? And could even lower interest rates cause profits to be concentrated to more lines?

    4. Could an economy go through a bust without the interest rates rising nor the “crack up” boom occurring?

    These are some of the questions that I have for the business cycle, and I appreciate the time to answer my 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:


    2. So specifically why does the structure of production lengthen? I understand that resources are diverted to higher stages of production because the NPV of the projects are now profitable, but what does it mean to lengthen it? Talking about the example, you said resources must be diverted to expand production capacity. So does the lengthening of the capital structure mean to divert resources to projects that will take time, but increase production in the future?

    4. For this, I mean would interest rates have to rise for a bust to occur? Could the Federal Reserve (assuming there isn’t too much inflation) be able to hold a certain interest rate down forever (assuming we never get the crack up boom)? If a bust would still occur, how so?

    5. After reading Joe’s and Murphy’s article (from 2008), I do have another question, and forgive me if you did say this in one of the lessons (I will go back to watch if you did). It’s about capital consumption. How does it occur under illusory gains? In Murphy’s article (The Importance of Capital Theory), he talked about how resources (labor), in his example of the island, are not put to maintaining capital. In Joe’s article, he said: “On the real side, the increase in the prices and profitability of consumer goods diverts factors from higher stages to consumer goods’ industries, thereby restricting the supply of resources available to add to or even replace the stock of capital goods.” So if entrepreneurs must maintain capital, why aren’t they doing it? And if the supply of resources are being restricted to add or replace capital goods, wouldn’t the prices of capital goods far surpass the industries’ profitability?

    Thank you for taking the time to answer my questions. I might be confusing a few things, but I just want to make sure I fully understand how the business cycle works.


    2. Lengthening means that the new set of production processes take more time to complete than the old set. For example, the old set might be (1) mine iron in existing mines using existing equipment (2) produce steel with the iron in existing steel mills using existing equipment (3) fabricate car fenders with the steel in existing fabrication factories using existing equipment (4) assemble cars with the fenders in existing auto factories using existing equipment. With lower interest rates a new set of production processes become profitable. The new set requires more mines to be opened up which use new equipment and more steel mills to be produced which use new equipment and more fabrication and auto factories to be build which use new equipment. The new set of might be (1) mine iron in existing mines using existing equipment (2) produce steel with the iron in existing steel mills using existing equipment (3) fabricate new drilling equipment with the steel (4) open up new mines which use new equipment…and so on until new cars are produced. The new set of production processes take more time to complete than the old set.

    4. The underlying factors affecting any particular interest rate include not only time preferences, by uncertainty associated with the loan, and anticipations concerning price inflation. All three of these factors work against the suppressing effect on interest rates of credit expansion. When the borrowed money from credit expansion is paid as income to those who produce the goods being bought with the borrowed money, they disburse it according to their time preferences which reduces the supply of credit from its artificially expanded amount and raises interest rates. As credit expansion proceeds, the additional credit must be extended to less credit worthy borrowers. Interest rates rise as risk premiums grow. Credit expansion occurs via monetary inflation, which tends to push the purchasing power of money down. Interest rates rise to compensate. Fed monetary inflation and credit expansion cannot stay ahead of these underlying factors indefinitely. The reason is people are always striving to economize. Imagine what would happen if the Fed engaged in monetary inflation and credit expansion of a small amount for a short time, say $10b for a month. Interest rates would quickly recover their time preference level keeping the losses from malinvestments to a minimum. People are engaged in the same economizing counter-reaction to Fed expansion even if it goes on for a long time in large amounts.

    5. What Joe argues is that the two tendencies–for resources to move to the higher stages and to the lower stages–cannot be satisfied consistently. At most, resources are pulled from stages in the middle of the capital structure to the higher and the lower stages (where profit is larger at least initially), which implies that the new larger capital structure set in motion by building up the higher stages cannot be completed for lack of resources to build-up the complementary middle stages. When the demand for middle-stage capital goods grows in intensity, the profitability of shifting resources from the higher and lower stages reveal the malinvestments made there.

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