14 May 2009

Austrian Business Cycle Theory and the "Rational Expectations" Objection

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The most typical objection to the ABCT from mainstream economists is that it apparently violates “rational expectations.” Loosely: Why don’t businesspeople learn to be careful when the Fed lowers interest rates?

Here [pdf] is an excerpt of a paper I wrote while teaching at Hillsdale. It has all the Bayesian bells and whistles, and gives a pretty neat model (or so I thought) of the Mises-Hayek story with all the Greek letters you could want. The referees at the Austrian journals thought otherwise, but in retrospect there was some extraneous stuff I put in the critique of Carilli-Dempster (which I’ve removed from this excerpt).

Anyway, this is how I think central banks make market economies more boom-prone, and also why they yield more sluggish growth. Yes, entrepreneurs do try to anticipate the Fed’s moves, but the presence of the Fed makes interest rates less informative of underlying scarcity. So you get more booms than you otherwise would, and you also get more missed opportunities than you otherwise would. Hence, lower average growth in the long run, plus the occasional boom-slump thrown in for good measure.

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