August 20, 2014 at 4:22 pm #18409THOMAS.BEHNKEMember
Hey Professor Herbener,
Below is a very brief summary of of the business cycle. Can you please check to make sure it’s correct? I just want to make sure that I understand it correctly.
1.) Fed floods the market with cheap credit, lowering interest rates
2.) Businesses begin to take on projects that they wouldn’t normally take on
3.) Demand skyrockets for the products created in the bubble (ex: houses in ’08), thus raising prices
4.) The demand eventually comes to a halt for 1 of 4 reasons,:1.) because the banks made too many loans, so they need to contract the money supply, 2.) because the demand was satisfied…most people that wanted a house already received their house, thus driving down the price of houses; 3.) inflation due to the cheap credit finally sets in, making most consumers start saving instead of spending, or 4.) the costs of production increased (ex: the demand for house building drove up the price of wood and metal, but the consumer’s demand for houses eventually came to a halt.), making it not worth it for companies to follow through with their plans…effectively popping the bubble
5.) Prices on the given product are drastically reduced.
6.) Construction companies that are still in the process of creating the product are stuck, because it’s now not worth finishing through with their projects. They have to cut their losses and likely declare bankruptcy.
7.) Bankruptcy is filed, tons of employees are laid off (while others have their wages cut), the stock market crashes
8.) Banks (hopefully) start contracting the money supply and people start saving…interest rates are raised
9.) Investing starts up again, new companies are created, demand goes up, more jobs are created, and wages/prices eventually go back to normal
Thanks so much!August 21, 2014 at 6:20 pm #18410jmherbenerModerator
It’s important to emphasize that the Fed generated monetary inflation and credit expansion lengthens out the capital structure beyond what is sustainable given people’s time preferences. This mis-match between the capital structure and time preferences is what reverses the boom. So, the steps might be listed out as below:
1. Fed buys assets from banks increasing the banks’ reserves.
2. Banks create credit by issuing fiduciary media on their new reserves.
3. The greater supply of credit pushes down interest rates and funds riskier investment projects.
4. Demand for higher-order capital goods increases relative to lower-order capital goods because more timber must be cut and milled before more houses can be produced and more iron must be mined and milled into steel before more cars can be produced.
5. Resources shift toward higher-stages and away from lower-stages, but this shift is not supported by a lowering of people’s time preferences.
6. People reestablish their time preferences by spending and saving their incomes, which are larger with the greater stock of money, according to their time preferences. This restores interest rates to their higher levels, which collapsed asset prices.
7. Asset prices also decline because investors perceive the greater risk of investing further in the boom lines of production.
8. Lower asset prices reveal the mal-investments of the boom.
9. The collapse of asset prices makes banks insolvent since their assets are financial claims on the assets whose prices are falling, e.g., mortgages on houses.
10. Profits exist in reallocating resources to shorten the capital structure in a way that satisfies time preferences.
11. Entrepreneurs liquidate the mal-investments and reallocate resources. Once the capital structure is reconfigured, economic normalcy returns.
Take a look at Rothbard’s summary of business cycle theory in chapter 1 of America’s Great Depression:
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