Analysis of US Sectoral Business Cycles: A Quantitative Study of Austrian Business Cycle Theory

Abstract: According to Austrian Business Cycle Theory a policy-induced lowering of the short policy interest rate below an unobservable natural interest rate can lead to an unsustainable boom in the economy, resulting in misallocated capital. As the unsustainability of this boom eventually becomes apparent and corrected the misallocated capital gets liquidated and causes a recession. It is thus of interest to evaluate the theory to find if and how a policy-induced lowering of the interest rate affects the output of an economy. This thesis investigates the validity of the Austrian Business Cycle Theory using series of capital’s share, labour’s share and output for ten sub-industries of the American economy between 1947 and 1997. These are included in a sector-specific Cobb-Douglas production function. Given the characteristics of the data and the cointegrating relationship between the series we deploy a Vector Error Correction Model, using the difference (spread) between three estimated natural interest rates and the short policy interest rate as an exogenous variable. We treat a positive spread as an expansionary policy and investigate how it affects the output of each industry. Although parts of the results in our study lend support to the Austrian Business Cycle Theory we conclude that there is not enough evidence to support it; the results are largely inconsistent with theory and not statistically significant to a sufficient extent.