Demand for Money and Hayekian Triangles

Abstract

The trigger of the Austrian (Hayekian) business cycle theory lies in the money-supply shock that deflects the market rate of interest from the natural level. Hayek (1935) developed a simple graphical tool to plot dynamics of the capital structure after this shock. Freezing the money supply is hence the early Hayek (1928) recommendation for monetary policy to prevent business cycles. Later, Hayek (1935) realised that changes in the velocity of circulation may have similar effects as the money-supply shocks. As a result, Hayek recommended to stabilize MV in the equation of exchange. However, he had never extended his graphical tool, the Hayek triangle, to describe dynamics of the capital structure after the shocks to the demand for money (i.e. velocity shocks). This paper tries to fill this gap. Changes in the money demand are plotted in Hayekian triangles. Since the nature of the demand for money is not unambiguously defined, the paper discusses whether real money balances that people hold reflect their demand for present goods or for future goods. The impact on the Hayek triangle then depends on how greater (lower) demand for money affects the flow of income; i.e. whether people (dis)hoard part of their income normally allocated on (real) consumption goods or on saving. This re-allocation then critically affects subsequent dynamics of the capital structure and the business cycle.