FREE ESSAY ON HAYEK'S CONTRIBUTION TO THE BUSINESS CYCLE.

HAYEK'S CONTRIBUTION TO THE BUSINESS CYCLE.

Friedirch August von Hayek was born in Vienna on May 8, 1899 and died on March 23, 1992,
in the city of Freiburg in Breisgan in Germany. Hayek was a central figure in
20th-century economics and he represented the Austrian tradition. After Hayek served
military service, he became a student at the University of Vienna where he got his
doctorate in law and political science. In 1923-4, Hayek visited New York and then
returned to Vienna where he continued his work. Hayek became the first director of the
Austrian Institute for Business Cycle Research in 1927. He also gave some lectures in
England at the London School of Economics in 1931. In England, he participated in such
debates as monetary, capital, and business-cycle theories during the 1930s. Hayeks'
contributions were very important.
To describe, business cycles, one has to examine the historical record of a nation's
overall economic performance. It is a pattern of long-term growth marked by alternations
of expansion and contradiction. These recurrent alternations above and below the
long-term trend are business cycles (Outhwaite, 55). The term economic fluctuations is
used to describe the same phenomena. Economists have distinguished many cause of the
business cycle. There are some factors outside the economic system and those within it.
Outside causes such as war and major inventions are referred to exogenous factors.
Whereas endogenous factors belong to the internal working of the economy itself and its
tendency to fluctuate over extended periods (Outhwaite, 56). Before World War II, the
emphasis was put on endogenous factors, and thus theories such as monetary;
overinvestment; underconsumption; psychological were more important than others. In
general, all cycle theories involve some kind of cost maladjustment. 
F. A. Hayek was one of the many economists who, indeed, explained overinvestment theory
in a monetary sense. Overinvestment theory is related to the overproduction-type
theories. Those theories include consumer goods, capital goods, or investment of money or
credit. They may stress fixed capital against circulating or liquid capital (Haney, 667).
However, the overinvestment theory assigned a crucial role to the acceleration principle,
according to which a mere decline in the rate of increase in business sales could give
rise to an absolute decline in the production of investment goods (Outwaite, 56). Hayek
examined the role of money and the banks in causing economic fluctuations. He showed how
sudden injection of credit into economy could cause changes in the relative prices
between goods and lead to overinvestment that cannot be maintained. When money and credit
vary, it sets up a train of events which draws resources into places where they would not
normally go. In particular, an increase in credit stimulates investment (Butler, 8).
Thus, Hayek shows that it is a response to the false signal of new credit being created,
and therefore this investment cannot be maintained.
Hayek concentrates on the initial disturbance that starts a cycle. It is used to create
new bank credit in the shape of unwarranted advances to enterprises. He considers money
(credit) as a factor to explain the cycle theory. 
The elasticity of the money supply (MV) is what allows and facilitates the disequilibria
of business cycles. By expanding the currency, malinvestments in capital are generated,
which are not productive enough to be maintained (Haney, 681).
Having said this, Hayek makes two points here. He talks about voluntary saving and
enterprisers' anticipation of rising prices. The former is concerned with the changes in
capital structure brought about by changes in the volume of money. It is the difference
between voluntary saving and the creation of new credit currency by banks. In particular,
Hayek describes the self-reversing real effects of credit expansion. He states that all
new capital goods which are created with the help of a credit expansion (voluntary
savings being constant) will be destroyed during the crisis which necessarily follows the
upward phase of the cycle (Colonna, xi). The new credit currency is considered to be
inflation and cannot be maintained whereas voluntary savings are production and can be
maintained. In Hayek's words 
In a free market society newly created money can never take the place of true voluntary
savings: money expansions do not have temporary distorting effects on the price system
and on the directions of production, but these effects are not in harmony with the free
choices of the consumers, money will never be able to change permanently the relative
scarcity of capital (Colonna, xi).
By saying this, Hayek showed the integration of monetary and capital theory.
In his second point, Hayek discusses how important the enterprisers's anticipation of
rising prices is. The entrepriser, anticipating rising prices, and aided by money rates
below the equilibrium rate, plunges into overinvestment (Haney, 682). Now, Hayek
developes a third point. He calls it the vertical structure of production, and the
different effects of price rises on the various stages (Haney, 682). Here, Hayek talks
about different goods and their total demand. He mentions production goods, intermediate
goods, and consumption goods. Hayek introduces the term forced savings which means
inability to buy the usual quantity of consumers' goods.
As banks having excess reserves encourage businessmen to borrow at below-normal interest
rates, an overexpansion of investment develops. The roundabout process of producing by
means of capital goods begins, and the spending of the new credit raises expenses and
prices before the incomes of consumers can rise (Haney, 682).
From this explanation, forced saving results. Hayek states that this phase will continue
as long as the investment feeds on new bank credit, and thus exceeds voluntary savings
(Haney, 682).
Hayek puts an emphasis on the highly technical area of trade-cycle theory after 1931. He
concentrates on the Ricardo effect in that period.
In a boom the rising demand for consumer goods drives up their prices, leading to a fall
in real wages. This, in turn, leads to an increase in investment demand, but this is
coupled with and eventually offset by a fall in capital: output ratios as real wages fall
(Tomlinson, 5).
However, Hayek argues that investment will tail-off in a slump even though profits are
rising (Tomlinson, 5). He relates the Austrian theory of capital to the business cycle in
order to show that a rising level of consumption must reduce rather than increase the
rate of investment. Hayek shows that 
A rise in the demand for consumer goods, with money wages and interest rates remaining
unchanged, by causing an increase in prices of consumer goods and a decrement of real
wages, will lead to a fall in the demand for capital goods thereby causing unemployment
(Palgrave, 198).
The Ricardo-Hayek effect comes from Ricardo's argument: a general rise in money wages
leads to a substitution of machinery for labor (Blaug, 571). Hayek thinks that Ricardo's
statement is misleading. Hayek, himself, tries to prove that if the relative prices of
labor and machines change, a rise in wages will induce substitution of capital for labor,
and vice versa.
A rise in the ratio of output to input prices increases the annual rate of profit on
working capital more than on fixed capital. This induces the firm to invest its liquid
capital funds in processes with a high rate of turnover. When the fall in real wages is
general, the result is that the average period of turnover of gross investment
expenditures in the economy as a whole declines; in other words, the average period of
production is shortened (Blaug, 573).
According to Hayek, commodity prices rise faster than money wages in the upswing of the
business cycle. Labor will be replaced with machinery, if this higher price-wage ratio
persists. Therefore, Hayek draws a conclusion that 
The fall in real wages leads to changes in the relative profitability of different
methods of production in favor of shorter or less roundabout methods. At some point,
investment demand for capital widening in response to expanding consumer demand for
current output - the demand for more machines of exactly the same type as before - is
more than offset by this type capital shallowing, and total investment demand in the
economy falls off (Blaug, 571).
Controversy, when there is a depression the rising level of real wages brings about a
revival of investment as capital deepening - the tendency to adopt more durable machines
- begins to offset the decline in induced investment (Blaug, 571).
The Ricardo-Hayek effect is dynamic because it deals with transient phase. It includes
fixed and circulating capital assets. The essence of this effect is that 
Profits will be higher on the method with the higher rate of turnover, not because they
would accrue at a higher rate after the new equilibrium but because the profits on the
less capitalistic method will begin to accrue earlier than those on the more capitalistic
method (Palgrave, 199).
In other words, the new position, which will be achieved, depends on time because during
the transition the behavior of the firms is affected by the profits accruing to them as
the adjustment process progresses.
There is no doubt about Hayek's theory. It provides an adequate basis for understanding
modern cycles. In his statement, Hayek points out various psychological and technological
factors such as entrepreneur anticipations, consumption habits, and industrial structure.
Hayek saw the business cycle  as resulting from the noncorespondance of plans of savers
and investors when important market signals - relative prices - are falsified by previous
monetary disturbance (O'Driscoll, 10). Hayek contributed to the business cycle by
providing the overinvestment theory.
A depression ensues when investment funds cease to be readily available and thereby leave
incomplete investment projects that have already been constructed but require
complementary projects, the construction of which has come to a halt (Spiegel, 543).
In sum, any change takes time and needs adjustment costs. In particular, changes to the
structure of production are inevitable in an investment boom. The rate of interest rises
once the boom in underway and thus, a higher rate of interest tells against more about
roundabout methods. To conclude, one may say that Hayek's contribution to the business
cycle provides a basis for interpreting economy in the 19 and 20 century.
Bibliography
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