Entrepreneurial Miscalculation and Business Cycles: How Interest Rate Targeting Distorts Capital Budgeting

Abstract

This article, using Austrian Business Cycle Theory, shows how entrepreneurs and business managers are vulnerable to central bank monetary policies targeting interest rates. These policies distort market signals used as inputs in widely used capital budgeting metrics. Their reliance on nominal cash flows—together with their dependence on market-based discount rates, themselves directly or indirectly influenced by central bank policy—induces entrepreneurs to misestimate the real future profitability and feasibility of investment projects. Based on distorted market signals, entrepreneurs and business managers ignite an unsustainable economic boom. The divergence between ex ante and ex post profitable investment projects is widened because of business miscalculation leading to a cluster of errors that eventually results in the bursting of an economic boom. Therefore, although the exogenous distortion of market signals is a necessary condition of a business cycle, its ignition is purely endogenous.