What Is Real Business Cycle Theory
Why Is Money Neutral In The Real Business Cycle Model

We’ve been looking at Good Money Part I: The New World, by Friedrich Hayek. It has a number of Hayek’s papers from the 1920s and 1930s. Today, I’ll talk about the last three papers in the book. Although I am not going into much depth here, I think this has been a worthwhile review of Hayek’s early thinking, which, as we will see, continued throughout his life.

Oct 11, 2004 Why real business cycle theory is important. Most nineteenth century theories of the business cycle were real (non-monetary) in nature, often involving agricultural causes. The harvest is bad and next thing you know, the economy stands in ruins. A pretty good theory when agriculture accounts for more than half of gdp. In the real business cycle (RBC) model: a. What causes output to fluctuate in the RBC model? Why is money neutral in the RBC model? Should the government act to stabilize output in the RBC model?

January 13, 2019: Good Money, Part I: The New World, by Friedrich Hayek
February 10, 2019: Good Money Part I #2: Hayek’s Early Enthusiasms
February 16, 2019: Good Money Part I #3: The Depression Years

“Intertemporal price equilibrium and movements in the value of money” dates from 1928. So, we are again in the pre-Depression period. The paper is mostly a muddle about “evenly-rotating economies” and the like, and seems to have inspired von Mises to later un-muddle the muddle (in Human Action) with his criticisms of this line of thinking. Sometimes Hayek emerges from the haze of ratiocination and blurts out what he really thinks, which gives us something to talk about. This one caught my eye:

Only if the quantity of the means of exchange could be fixed once and for all would it be possible to eliminate merely the most important influences from the money side discussed above, influences which prevent the automatic adjustment of the economy to changes in external conditions. (p. 217.)

This may be the source of ideas that popped up later, the notion that any increase in the “money supply” at all constitutes “inflation.” Hayek seems to think that any addition to the “money supply” creates distortions. This doesn’t really happen, if the additional supply meets additional demand. For example, let’s say that you have $100 of cash in your wallet. Sometimes it is more than $100, and sometimes less, but on average it is $100. You are “demanding” $100 through your cash-management habits. This $100 has to come into existence by some means, and so $100 is created, or “supplied,” to meet your “demand.” Now let’s say that you withdraw $100 from your banking account (which contains, on average, $3000), and now you have $200 on average in your wallet. Your cash-holding habits have changed. Sometimes it is more than $200, and sometimes less, but on average it is $200. Note that this change in your cash-holding habits can come about without any change in your spending habits. You spend the same amount each month, on the same things. The only difference is that you have $200 in your wallet instead of $100. This will have virtually no effect on the economy as a whole. (In practice, you will have to come up with the extra $100 by some means. Perhaps you will reduce your bank balance by $100, or perhaps you will reduce your spending, or increase “savings”, by a one-time adjustment of $100.).

Consider if you threw trillions of dollars of paper bills out of a helicopter. People picked up the trillions, and put them in shoeboxes beneath their beds, and did not change their habits in any way. Since their behavior is unchanged, obviously the economy as a whole is unchanged. A bunch of paper went from a helicopter into shoeboxes. Of course that is not likely to happen in the real world, but it shows how an increase in money supply does not have “inflationary” influences if it is matched with an increase in demand.

Hayek rejects this idea explicitly. Real money pppoker clubs.

On the Origin of the Theory that the Quantity of Money Must Be Accommodated to the ‘Demand for Money’

There is no basis in economic theory for the view that the quantity of money must be adjusted to changes in the economy if economic equilibrium is to be maintained or–what signifies the same–if monetary disturbances are to be prevented. (p. 220.)

Why Is Money Neautral In The Real Business Cycle

The reason for this, Hayek asserts, has something to do with the “price-specie flow mechanism” or the idea that gold flows are related to “trade imbalances.”

Assume, firstly, that there is a rise in the agricultural output of a country with lower costs of production, and that therefore it is the recipient of an inflow of gold. The reason for the inflow is familiar: Money always flows to the place at which its purchasing power is greatest. (p. 221.)

Hayek rightly notes that this is silly, but he doesn’t figure out that it is silly because it doesn’t exist. We can see why Hayek thinks that a gold standard causes changes in the money supply due to inflows and outflows of gold from somewhat random, unrelated events–with the natural conclusion that changes in money supply from random, unrelated conditions produces economic distortions. Throughout this discussion — and it does go on and on in this fashion — there is little mention or understanding of the idea that the ideal state of a currency is stability of value, that gold provides an excellent approximation of this ideal, and that the mechanisms of the gold standard allow for the adjustment of supply to meet demand at that gold parity. He is forever looking for economic distortions arising from changes in the quantity of money, while ignoring changes in the value of money. Mises cleared a lot of this up later on, I am happy to say, although it appears that Hayek did not benefit from this even later in his life.

“On Neutral Money” is a refreshingly brief (three pages) paper from 1933, in which Hayek again demonstrates that he is “not ready for prime time.”

The concept of neutral money was designed to serve as an instrument of theoretical analysis, and should not in any way be set up as a norm for monetary policy, at least in the first instance. The aim was to isolate the influences which money actively exerts upon the economic process, and to establish the conditions under which it is conceivable that the economic process in a monetary economy, and especially relative prices, are not influenced by any but ‘real’ determinants. (p. 228-89)

Readers will recognize that this is nearly exactly what I express in my own writings (notably Gold: the Monetary Polaris), which is also basically verbatim from von Mises’ Human Action. Real money tree buy. I did not make this stuff up. Nor did von Mises. Hayek, however, rejects this view, with some rather obtuse arguments, and ends up concluding that:

It seems to me that the stabilization of some average of the prices of the original factors of production would probably provide the most practicable norm for a conscious regulation of the quantity of money. (p. 231)

What Is Real Business Cycle Theory

So we are again back at Hayek’s commodity-basket standard. Remember, this is 1933. The “commodity basket standard” and “stable purchasing power” arguments are, at that very moment, serving as justification (via George Warren and Frank Pearson) for Franklin Roosevelt’s intentional devaluation of the U.S. dollar. Hayek is apparently jumping on the devaluation bandwagon, tossing out his own justifications along the way.

“Price expectations, monetary disturbances, and malinvestments” dates from 1935. It has some interesting points, mostly about details of theories of “the business cycle.” If anything, it shows just how barren the study of “the business cycle” was in those days. You would think that, five years into the Great Depression, Hayek would have something interesting to say about “the business cycle,” but I struggle here to find anything worth mentioning. There is, for example, not a syllable about the many things that were happening that were unrelated to money and credit, such as tariffs, regulation and tax policy. There is some talk about a “credit cycle,” which I think does exist and does happen, and can be quite dramatic. It can be related to monetary conditions (as is almost always the ca

Why Is Money Neautral In The Real Business Cycle