Abstract

This paper endeavors to develop a modern theoretical underpinning of Friedrich August von Hayek’s business-cycle theory as published during the Great Depression in his book Prices and Production. According to Hayek, economic cycles are caused by monetary shocks, which distort the relative-price schedule across economic sectors. Possible consequences of these price distortions, which are also called “Cantillon effects,” include malinvestment and an unsustainable production structure, which sooner or later has to be corrected by a recession. It turns out that this type of economic fluctuation can be condensed into a simple two-sector overlapping generations model.

Highlights

  • Acollapse in aggregate demand, which is followed by sluggish price adjustments, is probably the most widely cited explanationThis paper has benefited from valuable comments and suggestions by Dirk Niepelt and an anonymous referee

  • This paper suggests that the cycle theory described verbally by Friedrich August von Hayek—and in a rudimentary form much earlier by Richard Cantillon—can be expressed through a simple overlapping generations model

  • When two sectors are introduced into the overlapping generations (OLG) model, it is possible for economic shocks to alter the relative prices of goods associated with these sectors

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Summary

INTRODUCTION

Acollapse in aggregate demand, which is followed by sluggish price adjustments, is probably the most widely cited explanation. The only exception is Beaudry, Galizia, and Portier (2016), who have employed a modern monetary model with search and matching frictions to show that a liquidation of overaccumulated capital can cause high levels of unemployment, which cannot always be corrected via Keynesian fiscal policy Against this background, this article endeavors to contribute to the literature by developing a simple theoretical framework that captures some of the key elements of the cycle theory put forward in Prices and Production. For this task, a model is warranted where individuals as producers and/or consumers decide to save and invest in different forms of capital, where money flows via specific sectors into the economy such that policy shocks can alter the relative-price schedule between these sectors and change the consumption, investment, and production structure.

THE CANTILLON-HAYEK CYCLE THEORY IN WORDS
Background
Notation and Basic Assumptions
Assumptions about the Production Functions
The Saving and Consumption Decisions
Capital Allocation and Production Structures of Different Lengths
Capital and Relative-Price Dynamics and the Steady State
Converging Cycles
SUMMARY AND CONCLUSION
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