Monetary Policy in a Hayekian Supply Side Model

In this paper standard macroeconomic models are combined with the Hayek-Garrison model of the business cycle in order to demonstrate in which way modern central banks are prone to initiate boom-bust-cycles through monetary policy. It is shown under which conditions such a policy will occur and why central bank authorities tend to be misled by an apparently stable price-level. Without central bank interference, productivity increases due to technological advances, other cost reductions or an increased supply of cheaper labor would bring about temporary deflation. Left to its natural path, rising profits and a higher purchasing power would move the economy towards an expansion and increased expenditures. However, with central bank interventions that are directed at maintaining the so-called price level, the monetary authorities will expand the money supply and transform a productivity-led wealth increase into a debt-driven boom, which produces the foundation for the bust later on. Basic Structure of the Model In this paper the commonly held notion is being challenged that when the economy achieves high rates of economic growth along with price level stability, monetary policy is at a neutral stance. It is shown that under the conditions of significant productivity gains, modern central banks create a credit-driven boom also when they achieve their inflation target. Based on Mises-Hayek’s business cycle theory (Mises 1912, Hayek 1931, 1941) as elaborated by Garrison (2001), the model presented here serves as a complement to the modern version of capital-based macroeconomics. Garrison (2001), Selgin (1994) and Salerno (2002) among others developed models that study the role of credit expansion in the business cycle and the role of deflation. The monetary expansion is the starting point of the boom bust cycle. Garrison in particular has advanced the Austrian theory of the business cycle by developing an approach that links features of standard macroeconomic modeling with Hayek’s theory of the business cycle. These models concentrate on the intermediate period, on the analysis of the production structure in the upswing and downswing phase of the business cycle. The model presented here puts active monetary policy at the center of the analysis. It elaborates