Unbiased Expectations and Hayek’s Business Cycle Theory

Abstract

Hayek’s business cycle theory does not depend on its traditional assumption of systematic predictive errors. To the contrary, the theory is also consistent with unbiased expectations where some people overestimate and others underestimate the length of an ongoing monetary expansion. The overestimating people tend to expect low real interest rates for an overly long period and invest in overly long production processes. They also tend to realize the error at the same moment—at the end of the monetary expansion, when they also liquidate the unprofitable investment. With the assumption of unbiased expectations, the theory predicts a cluster of observable errors and replicates the important features of Hayek’s canonical version of the theory.