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

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