The Austrian school of economics

 

Austrian

The Austrian school of economics, founded by Carl Menger, saw that the world was evolving and for the first time in history, people were making a positive impact on society and playing a “positive sum game”. Before the industrial revolution the primary economic objective was to obtain a larger share of the pie. But during the industrial revolution people saw times of economic growth without the requirement of taking a piece of the pie from a different nation. This caused a fault in mercantilism to become apparent. There was a possibility to make the pie bigger. This led to the Austrian school of economics amending the theory of mercantilism and changing it to individualism. This was a large contribution to the free market theory. The Austrian school of economics was revolutionary in terms of macroeconomic theories. They also gave insights to the laws of supply and demand, the theory of money creation, and the operation of foreign exchange rates.

 

Laws of supply and demand

The school accepts that the equilibrium in a supply and demand graph gives the market clearing price to sell the good/service in question. But it rejects the classical and neoclassical schools’ “cost production theory of value.” This theory, in a nutshell, the cost of production is the sum of all of the goods and services that goes into making/providing a service or good. The Austrian school disagrees with this. They believe that the cost of production is further determined by subjective factors based on the other uses of the resources used as it is determined by value of opportunity cost. (Opportunity cost - the second best good/service you could have purchased if you chose not to make the purchase that you did.) And that the price equilibrium is subjective to each individual.

Business cycle

The Business cycle is shown below. The line passing through the origin, the trend line, is the line which denotes growth rate and the overall movement of the economy. This graph shows the cyclical routine of the economy. The peak being an economic boom, the trough being a recession.

The Austrians believed that government intervention was the root of the nature of the cycle. They argue that the cycle is caused by a distortion in interest rates. The government’s attempt to manipulate the economy through interest rates was the cause of misallocated capital. When the interest rates are artificially changed to boost the economy, they lead to a temporary boom, but eventually a recession takes place due to the artificial interest rates. According to the Austrians, the government misallocates their resources to ill-suited industries such as construction and remodelling in the 2008 financial crisis. These short-term business adjustments ultimately cause unemployment to rise and real investment to fall. The prolonging of the recession only makes the inevitable recession worse.

The effect of Inflation

The Austrian school believes that the increase of money supply which is not supported by an increase in production of goods and services leads to an increase in prices. This is supported by

                                                                     VM=PQ

velocity of money*money supply=Price level*Quantity of goods and services produced   

Hence, if the money supply increases, without a change in quantity of goods and services produced or a change in velocity of money, causes an increase in price level.

However, the Austrians stated that the prices of all products in the entire economy do not increase simultaneously. This means that any inflation is bad, contrary to popular belief. The Austrians suggest that the disparity in the relative prices of goods is increased. In English, it means that goods/services that react to inflation before others makes that good/service provider rich, at the expense of the people purchasing the good/service. This is because the consumers’ wages have not increased yet therefore the product that the consumers purchase take up a larger portion of the consumers’ incomes. Moreover, if the government purchases large quantities of corn, due to the rightward shift of the demand curve, the equilibrium shifts to a greater price. Thus, the price of corn increases dramatically, causing a trail of an increased relative disparity of prices.

In conclusion, the Austrian school of economics is a fantastic school of economic thought, they are thinkers that outline problems in the modern society. I find this school one of the most interesting as they promote Laissez-Faire capitalism (extreme capitalism), however they contribute solutions to the modern-day problems in the economy. They argue for an entirely separate method of running the economy than that of the modern day.

One thing that I noticed during the writing of this blog, the Austrians seek economic growth above all else, not a high GDP figure like the modern society and they do not seek full employment like Keynes. As some of the topics in the blog. Such whether inflation is good or bad, the Austrians do not look for the increase in the velocity of money using an increase in money supply to boost the GDP. The Austrians in my opinion are forward thinking economists unlike Keynes, who we will be going over next blog