Capital-Based Macroeconomics: Understanding Sustainable Growth

2. One student at LSE in the 1930s recalls the "three-dimensional diagrams with which Hayek presented his ideas and which made them seem like something in the field of engineering." Another LSE student noted that Hayek wore "a thick tweed suit with a waistcoat and high-cut jacket." She nicknamed him 'Mr. Fluctooations' as he so often used that word and pronounced it in that way.“ -from Alan Ebenstein’s Friedrich A. Hayek: A Biography F. A. HAYEK

3. Sustainable and Unsustainable Growth An Application of Capital-Based Macroeconomics Based on the Theory of the Business Cycle set out by Ludwig von Mises and F. A. Hayek

4. Go To the original version of this show, which was created in 1999. Time and Money Table of Contents Go To Go To Go To Go To Go To Go To Part I: The Elements of Capital-Based Macroeconomics Part II: Integrating the Elements Part III: Saving as a Basis for Sustainable Growth Part IV: Legislating Low Interest Rates Part V: Manipulating Interest Rates with Money Part VI. Letting the Economy Grow

5. PART I Go To:Table of Contents The Elements of Capital-Based Macroeconomics

6. “Loanable funds” is the generic term that refers both to lending (which constitutes the supply side of the market) and to borrowing (which constitutes the demand side). Each side of the market for loanable funds is governed by the rate of interest. Saving, broadly conceived, underlies the supply of loanable funds. The Market for Loanable Funds

7. “Loanable funds” is the generic term that refers both to lending (which constitutes the supply side of the market) and to borrowing (which constitutes the demand side). Each side of the market for loanable funds is governed by the rate of interest. Saving, broadly conceived, underlies the supply of loanable funds. Borrowing by the business community constitutes the demand. The Market for Loanable Funds

8. “Loanable funds” is the generic term that refers both to lending (which constitutes the supply side of the market) and to borrowing (which constitutes the demand side). Each side of the market for loanable funds is governed by the rate of interest. Saving, broadly conceived, underlies the supply of loanable funds. Borrowing by the business community constitutes the demand. As recognized by both Eugen von Bohm-Bawerk and John Maynard Keynes, this market is better thought of as the market for investable resources. It keeps the macroeconomically relevant magnitudes of saving (S) and investment (I) in balance. The quantity axis measures saving (and investment) as the amount of output produced in a given period and made available for (and actually used for) the expansion of the economy’s productive capacity. The Market for Loanable Funds

9. The supply price of investable resources is measured by (and sometimes proxied by) the rate of interest. Though saving can actually take the form of lending through banking institutions, it can also take the form of retained earnings or the buying of bonds or equity shares. The demand price is similarly interpreted to include the various ways that the business community can take command of unconsumed output—which constitutes the investable resources. Consumer borrowing is netted out on the supply side. That is, the focus is on the funds lent collectively by income-earners/savers to the business community. In this graphical exposition, the supply and demand for investable funds results in a market-clearing interest rate of 5% with saving and investment amounting to $800 billion. The Market for Loanable Funds

10. The supply price of investable resources is measured by (and sometimes proxied by) the rate of interest. Though saving can actually take the form of lending through banking institutions, it can also take the form of retained earnings or the buying of bonds or equity shares. The demand price is similarly interpreted to include the various ways that the business community can take command of unconsumed output—which constitutes the investable resources. Consumer borrowing is netted out on the supply side. That is, the focus is on the funds lent collectively by income-earners/savers to the business community. In this graphical exposition, the supply and demand for investable funds results in a market-clearing interest rate of 5% with saving and investment amounting to $800 billion. The Market for Loanable Funds

11. Capital-based macro features consumption and investment as alternative ways to use resources. The alternative uses are depicted as a Production Possibilities Frontier (PPF).

12. Capital-based macro features consumption and investment as alternative ways to use resources. The alternative uses are depicted as a Production Possibilities Frontier (PPF). The PPF shows the maximum sustainable level of output as a locus of points representing all possible combinations of consumption and investment for a fully employed economy. Production Possibilities Frontier

13. Consider a particular point on the frontier. This point represents an economy that is fully employed (with the unemployment rate in the 5%-6% range). Hence, output is being produced at a sustainable rate. Production Possibilities Frontier

14. Consider a particular point on the frontier. This point represents an economy that is fully employed (with the unemployment rate in the 5%-6% range). Hence, output is being produced at a sustainable rate. Now consider a disequilibrium point inside the PPF. Production Possibilities Frontier The distance below the frontier reflects the idleness of labor and other resources. The unemployment rate is higher than 6%, suggesting significant cyclical unemployment. This point represents an economy in recession, producing fewer consumption goods and/or fewer investment goods than it could.

15. Now consider a disequilibrium point beyond the PPF. This point represents an overheated economy. The unemployment rate is below 5%. The level of output is unsustainable. (Points very far beyond the PPF are, of course, literally impossible. Production Possibilities Frontier

16. The second P in PPF suggests that it is actually possible for the economy to move along the frontier—a possibility denied by Keynes with his paradox of thrift. Increased saving moves the economy along the PPF in the direction of more investment; decreased saving moves the economy along the PPF in the direction of consumption. DEPRECIATION = $600 As long as gross investment is greater than depreciation, the economy will grow, as will be represented by an outward shift in the PPF itself. Investment in this framework is measured in gross terms. Suppose an investment of $600 billion is needed just to offset depreciation.

17. CONSUMABLE OUTPUT The vertical axis tracks the value dimension—with value at the end of the production process representing consumable output. Hayek conceived of a number of distinct stages of production, the output of each feeding into the next as input. P R O D U C T I O N T I M E Beyond the two-way division of resource usage captured by the PPF, capital-based macro tracks the intertemporalallocation of investable resources. Production time is measured along the horizontal axis. Each stage, then, has its own time dimension and value dimension. A stage’s value dimension reflects the discounted value of the future consumable output.

18. At a given point in time, an ongoing production process is characterized by activities in all the separate stages. CONSUMABLE OUTPUT Dividing the economy’s Production process into five stages is a matter of pedagogical convenience. STAGES OF PRODUCTION MINING REFINING MANUFACTURING DISTRIBUTIING RETAILING Identifying the stages as “mining” through “retailing” is only suggestive. The actual intertemporal structure of capital, of course, entails a complexity of interconnected production activities.

19. The resulting figure is known as the Hayekian triangle. Strictly speaking, the triangle constrains the production process to a particular type: continuous-input/point-output. The “value added” at each stage consists of two components: (1) the adding of further inputs and (2) the movement in time towards the ultimate yield of consumable output. CONSUMABLE OUTPUT S T A G E S O F P R O D U C T I O N For analytical purposes, the economy’s production process is conceived as a continuum of stages and is represented as goods in the making that gain value as they near completion.

20. C The Hayekian Triangle, then, has two mutually reinforcing interpretations. First, it depicts the production process that plays itself out over time. Second, it depicts the full complement of stages that exist at a given point in time. This second interpretation suggests that resources can be reallocated in either direction from one stage to another. Reallocation among the stages will affect the temporal pattern of consumable output P R O D U C T I O N T I M E While at each point in time there are goods in the making at each stage, the economy’s ultimate output can be identified with a temporal sequence of activities. Watch the goods in progress move through the stages.

21. PART II Go To:Table of Contents Integrating the Elements

22. The market for loanable-funds—a.k.a. investable resources—shows that the market-clearing rate of interest is 5%, at which saving and investment are in equilibrium at $800 billion.

23. The market for loanable-funds—a.k.a. investable resources—shows that the market-clearing rate of interest is 5%, at which saving and investment are in equilibrium at $800 billion.

24. The PPF shows that with $800 billion committed to investment activities, $2200 billion are available for current consumption. The market for loanable-funds—a.k.a. investable resources—shows that the market-clearing rate of interest is 5%, at which saving and investment are in equilibrium at $800 billion.

25. The Hayekian triangle depicts current consumption as the output of the economy’s multi-stage production process. The rate of interest governs the allocation of resources among the stages. An initial full-employment equilibrium is defined by: the Loanable-Funds Market, The slope of the hypotenuse of the Hayekian triangle reflects a rate of interest consistent with the rate that prevails in the loanable- funds market. the PPF, the Hayekian Triangle,...

26. …plus the representative stage-specific labor markets.

27. $600 If gross investment needed to offset capital depreciation is $600 billion, the economy is experiencing net investment of $200 billion.

28. $600 This additional capital is distributed among the stages of production in accordance with an unchanged rate of interest. The increase in productive capacity and hence in output is depicted by a shifting outward of the PPF and by a corresponding shifting of the supply and demand for loanable funds.

29. Watch the economy grow!

30. Watch the economy grow!

31. Watch the economy grow!

32. Watch the economy grow!

33. With gross investment greater than capital depreciation, the economy experiences secular growth. This rate of growth is sustainable. To the extent that increased incomes and wealth reduce the premium on current consumption and increase saving propensities, the economy will grow faster. We turn next to the effect of increased saving, whatever the underlying cause of the increase.

34. PART III Go To:Table of Contents Saving as a Basis for Sustainable Economic Growth

35. The supply of loanable funds registers people’s current saving preferences. Changes in saving behavior for the economy as a whole can stem from a change in demographics or from a change in attitudes toward saving. People may become more conscious of the need to save for their children’s education or for their retirement years. Suppose that, for whatever reason, people decide to save more.

36. The supply of loanable funds registers people’s current saving preferences. Changes in saving behavior for the economy as a whole can stem from a change in demographics or from a change in attitudes toward saving. People may become more conscious of the need to save for their children’s education or for their retirement years. Suppose that, for whatever reason, people decide to save more. The supply of loanable funds shifts to the right, registering the increased inclination to save, or equivalently, the decrease in time preferences. The interest rate falls from 5% to 2.3%, encouraging the business community to increase investment from $800 billion to $1000 billion.

37. The supply of loanable funds registers people’s current saving preferences. Changes in saving behavior for the economy as a whole can stem from a change in demographics or from a change in attitudes toward saving. People may become more conscious of the need to save for their children’s education or for their retirement years. Suppose that, for whatever reason, people decide to save more. The loanable funds market strikes a new equilibrium. Both saving and investment increase to $1,000 billion.

38. The PPF shows how the increased saving affects the mix of consumption and investment. For a given income, saving more means consuming less.

39. The PPF shows how the increased saving affects the mix of consumption and investment. For a given income, saving more means consuming less. The economy moves along the frontier, as current consumption is reduced from $2,200 billion to $1,780 billion. Resources are shifted away from production activities aimed at the present and near-future and toward production activities aimed at the more remote future.

40. A reshaping of the Hayekian triangle mirrors the move-ment along the PPF in the direction of investment and depicts the change in the time dimension in the production process.

41. With reduced consumption demand, the derived demand for labor and other factors of production in the late stages is reduced as well. In the early stages, demand for labor and other factors of production is increased, as the interest-rate effect more-than-offsets the derived-demand effect .

42. A wage-rate differential during the capital restructuring encourages workers to move from late stages to early stages.

43. A wage-rate differential during the capital restructuring encourages workers to move from late stages to early stages.

44. Watch the economy respond to an increase in saving.

45. Watch the economy respond to an increase in saving.

46. A saving-induced reallocation of resources among the stages of production skews the pattern of consumable output toward the future. People don’t just save; they save-up-for-something. Consumption is down only temporarily—during the transition to new growth path. Early-stage investments during this transition allow the increased future demands for consumption goods to be accommodated. The economy grows more rapidly than before. Now watch the economy grow!

47. Now watch the economy grow!

48. Now watch the economy grow!

49. Now watch the economy grow!

50. Saving & Growth An initial increase in saving, attributable to a change in intertemporal consumption preferences, is depicted by a movement along the PPF. The increase investment made possible by this initial saving allows PPF to shift outward in larger increments than before the change in intertemporal preferences.