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Expectations and the Austrian Business Cycle Theory

According to the Austrian Business Cycle Theory (ABCT) the artificial lowering of interest rates by the central bank leads to a misallocation of resources because businesses undertake various capital projects that prior to the lowering of interest rates weren’t considered as viable. This misallocation of resources is commonly described as an economic boom.

As a rule businessmen discover their error once the central bank—that was instrumental in the artificial lowering of interest rates—reverses its stance, which in turn brings to a halt capital expansion and an ensuing economic bust. From the ABCT one can infer that the artificial lowering of interest rates sets a trap for businessmen by luring them into unsustainable business activities that are only exposed once the central bank tightens its interest rate stance.

Critics of the ABCT maintain that there is no reason why businessmen should fall prey again and again to an artificial lowering of interest rates. Businessmen are likely to learn from experience, the critics argue, and not fall into the trap produced by an artificial lowering of interest rates. Correct expectations will undo or neutralise the whole process of the boom-bust cycle that is set in motion by the artificial lowering of interest rates. Hence, it is held, the ABCT is not a serious contender in the explanation of modern business cycle phenomena.

According to a prominent critic of the ABCT, Gordon Tullock,

One would think that business people might be misled in the first couple of runs of the Rothbard cycle and not anticipate that the low interest rate will later be raised. That they would continue to be unable to figure this out, however, seems unlikely. Normally, Rothbard and other Austrians argue that entrepreneurs are well informed and make correct judgments. At the very least, one would assume that a well-informed businessperson interested in important matters concerned with the business would read Mises and Rothbard and, hence, anticipate the government action.[1]

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