Definition Of Supply And Demand

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Austrian Business Cycle Theory and the Natural Rate of Interest

The Austrian business cycle/trade cycle theory that Hayek proposed in the early 1930s took up Knut Wicksell’s hypothetical “natural rate of interest” and uses that concept in its analysis. In ABCT, the market rate of interest (a monetary rate) falls below the natural rate (the return on capital). As resources are drawn away from production in lower-order stages that produce consumer goods, there is inflation in consumer goods relative to capital goods, and then interest rates rise. This supposedly causes a crisis as many investments in higher-order stages of production cannot be profitably maintained, resulting in liquidation and higher unemployment. “Earlier writers defined the natural rate of interest concept in various ways. Hayek originally defined the natural rate as the rate of interest that would prevail if savings and investment were made in natura ; that is, without any distortionary monetary effects [i.e., without money]. Mises (1978, p. 124) defined the natural rate of interest as the equilibrium rate for the capital structure. Later treatments defined the natural rate as the real marginal productivity of capital or as the interest rate which equalizes ex ante savings and investment” (Cowen 1997: 95). “ The rate of interest at which the demand for loan capital and the supply of savings exactly agree, and which more or less corresponds to the expected yields on the newly created real capital, will then be the normal or natural rate. It is essentially variable. If the prospects of employment of capital become more promising, demand will increase and will at first exceed supply; interest rates will then rise as the demand from entrepreneurs contracts until a new equilibrium is reached at a slightly higher rate of interest. At the same time equilibrium must ipso facto obtain—broadly speaking, and if it is not disturbed by other causes—in the market for goods and services, so that wages and prices remain unchanged” (Wicksell 1934: 193). “There is a certain rate of interest on loans which is neutral in respect to commodity prices, and tend neither to raise nor to lower them. This is necessarily the same as the rate of interest which would be determined by supply and demand if no use were made of money and all lending were effected in the form of real capital goods. It comes to much the same thing to describe it as the current value of the natural rate of interest on capital.

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