Empirical Testing of the Austrian Business Cycle Theory : Modelling of the Short-run Intertemporal Resource Allocation

Abstract: The  Austrian  Business  Cycle  Theory  (ABC)  provides  a  qualitative  explanation  of  why economies go through ups and downs in terms of national income, production output and labor employment. The theory states that interest and money supply policy distort the time preferences of economic agents. If the monetary authority reduces the interest rate through artificial credit expansion the new economic conditions induce both increased production and consumption. The  framework of  the Austrian  theory depends on  savings  to  fuel  investments, i.e. reduced consumption in order to create increased future consumption. Artificially  induced  expansions  create  a wedge between  these producer  and  consumer preferences, and prolonging of the process widens the gap between the economic state and the free market  equilibrium which  is  long-term  sustainable. When  the  financial  system  eventually is unable to maintain inflation of credit to uphold the economy, there will be abandonment of capital investments, resulting in an unavoidable recession. The purpose of this thesis is to analyze the theory from a short run perspective, using data from  the United Kingdom  economy. The  theory has previously primarily been  tested  in long run perspectives and mainly on the American economy. To achieve the noted a model was constructed based on the description of the theory by economists Hayek and Garrison, members of the Austrian school of economics. To empirically model the ABC theory the ratio between consumption and investment, the intertemporal  resource allocation, was  calculated and used as a dependent variable  in  regressions with money aggregates, credit and interest rate gap as independent variables. The empirical findings give some support to the theory, with a number of those findings directly in favor of the theory. Credit was shown to better explain changes in the C/I ratio than money aggregates, indicating that credit is more directly suited for investments. The coefficient for the interest rate gap, the difference between the natural interest rate and the market interest rate, showed strong significance. Overall differences between economic expansions and recessions were found statistically significant, which lends support to the model.