Austrian business cycle theory and monetary equilibrium

As Steve Horwitz has shown, the insights of Austrian macroeconomics and monetary disequilibrium theory can be combined to yield a powerful paradigm for understanding how monetary policy affects the economy.  Crucial to this synthesis is the neutrality of money.  Remember that money is neutral when it facilitates exchange, but does not distort the terms of exchange.  Money is approximately neutral when conditions of monetary equilibrium hold—when individuals’ demands for money equals the supply of money at the going price level, which itself gives us information about the ‘price’ of money.

When monetary disequilibrium exists due to an excess supply of money, Austrian-like dynamics can result.  Assuming a central bank injects the newly-created money into capital markets, and that this monetary injection was not anticipated, the wedge driven between the natural and market rates of interest will facilitate a miscoordination between consumption and investment.  This miscoordination will manifest in incompatible production and consumption plans.  Eventually this must result in a bust, and the economy must grope back towards sustainable production and consumption processes.

What the monetary disequilibrium insights add is an understanding that monetary non-neutrality does not necessarily follow from any increase in the money supply.  Monetary equilibrium can be dynamic—so long as the money supply is growing at the same rate as market actors expect, ABCT-esque malinvestments will probably not result.  Note that this result is compatible with constant inflation.  If the money supply is growing at 5% every time period, and money demand only grows at 2%–in line with population growth, perhaps—then the result will be ‘steady state’ inflation of 3% per time period.  Thus ‘ordinary’ monetary equilibrium, with quantity of money supplied equaling quantity of money demanded at a specific, and unchanging, price level, is a special static case of the more dynamic model.

It is when money growth unexpectedly diverges from a trend growth path perceived by the market that we begin to observe problems.  If the rate of money growth slows down unexpectedly, there can be a temporary downturn until market actors adjust market prices to reflect the new, slower rate of money growth.  If the rate of money growth increases unexpectedly, we’re back to the start of the ABCT story.

Incorporating ABCT into monetary disequilibrium theory is important because it gives us a more general framework for understanding how monetary factors relate to macroeconomic fluctuations.  Not all increases in the money supply have resulted in boom-bust cycles; not all falls have resulted in painful deflationary spirals.  The compound theory highlighted above is a parsimonious explanation of why.