Accounting for the Business Cycle: Nominal Rigidities,

Factor Heterogeneity, and Austrian Capital Theory*


Robert F. Mulligan

Western Carolina University and

the State University of New York at Binghamton


Abstract.  An Austrian interpretation of the New Keynesian small menu cost model of the business cycle is proposed.  Austrian and New Keynesian business cycle theories share the feature that the cycle is generated by rigidities which prevent the economy from adapting instantaneously to changing conditions.  Austrian business cycle theory is capital-based, focusing on credit expansion which artificially lowers interest rates and causes an investment boom and unsustainable business expansion.  In contrast, the New Keynesian small menu cost model of the business cycle is based on nominal rigidities which prevent markets from clearing.  Small menu costs introduce dichotomous behavior, where firms find it locally optimal to avoid instantaneous output price adjustments in the face of the cost, but this local optimum results in economy-wide output and employment fluctuations which are much greater in relative magnitude.  The small menu cost model of the business cycle is extended and reinterpreted in light of Austrian business cycle theory with heterogeneous, multispecific capital, thus providing a rigorous formalization of the Austrian business cycle.  The Austrian interpretation of this New Keynesian model fortuitously addresses several of its shortcomings.


Key words:  Austrian business cycle theory, New Keynesian small menu cost model, Hayekian triangle


JEL classification: B53, E12, E23, E32


Solomon: ... You take this table ... You can't move it.  A man sits down to such a table he knows not only he's married, he's got to stay married -- there is no more possibilities.

Arthur Miller (1968) The Price Act 1


1.  Introduction

Every economic decision has an opportunity cost, and decisions to invest in long-lived capital equipment have long-lived and especially onerous opportunity costs.  As Arthur Miller's appraiser might conclude about capital equipment, "it's furniture and you're married to it."  Once entrepreneurs commit to a definite production plan, they surrender many possible future states in return for the opportunity to pursue one;  future possibilities are limited by the act of choosing.  In effect, "there is no more possibilities."   However, until entrepreneurs commit to a production plan, they are no more than potential entrepreneurs[1].  Austrian business cycle theory is unique in recognizing the role of time preference in coordinating a production structure managed by many independent entrepreneurs with subjective knowledge, information, preferences, and unique abilities. 


The Hayekian triangle (figure 1; Hayek 1931:39; subsequently developed by Hayek 1933, 1939, 1941) illustrates the production structure.  In the most stylized case, the interest rate is proportional to the slope of the hypotenuse.  The steeper hypotenuse reflects the higher interest rate and consumers' increased time preference – in this higher-interest environment, consumers are less willing to wait for immediate consumption goods.  Conversely, when interest rates fall, the structure of production becomes more roundabout, redistributing marginal resources toward productive activities with lower rates of return.  These more roundabout production processes produce more final output but require more production time. 


Although the Hayekian triangle is a general model of intertemporal resource allocation, it is generally interpreted as a model of how interest rates determine allocation of investment versus consumption spending, and how the production structure is manifested in the capital stock.


Figure 11

The Hayekian Triangle

Text Box: Consumable Output

Mining          Refining        Manufacturing Distribution   Wholesaling    Retailing





















Production Time



1 Source:  Garrison 2001, p. 47.

Because this paper discusses a formal model of a kind which is uncommon among the Austrian school, it attempts to answer Spadaro's (1978) call for selective adoption of rigorous formalism.  New Keynesian models of the business cycle emphasize the result that insignificantly suboptimal behavior causes aggregate demand shocks with significant real effects (Akerloff and Yellen 1985).  Resistance to changing prices or wages plays the same role in the New Keynesian models as resistance to adjusting the capital structure plays in Austrian business cycle theory: both rigidities or intertial properties keep the macroeconomy from full general equilibrium, and introduce large fluctuations in aggregate output and employment.


The paper is organized as follows: section 2. The Austrian Theory of the Business Cycle, summarizes the theory; section 3. Qualitative Applications and Earlier Empirics, reviews applications of the theory to historical data; section 4. The New Keynesian Small Menu Cost Theory of the Business Cycle summarizes that theory; section 5. An Austrian Critique of the Small Menu Cost Model, develops some Austrian objections to the small menu cost model; section 6. An Austrian Model of Inertia in the Production Structure, reinterprets the small menu cost model in light of Austrian business cycle theory; and finally section 7. Conclusion, provides concluding comments.


2.  The Austrian Theory of the Business Cycle

This section briefly summarizes the Austrian capital theory on which the reinterpretation of the small menu cost model is based.  Hayek (1935:136-139), Mises (1949: 550-566), and Garrison (1986:440; 1988; 2001:71-73) draw a fundamental distinction between ordinary changes in time preference and policy-induced changes in interest rates.  Only a decrease in interest rates caused by credit expansion can drive the business cycle.  According to Austrian business cycle theory, there should be no cycle if the decrease in interest rates is due to a general lowering of time preference.  Because production takes place over time, time preference assures outputs from each stage have greater expected value than the sum of inputs (Mises 1949:483-488; Rothbard 1962:323-332; Garrison 1985:169; 2001:46). 


The interest rate is the rate of time discount implicit in the pattern of prices of productive resources, including capital goods.  Garrison cautions (1985:169-170; 2001:50) this is not necessarily the same as the loan rate determined in the loanable funds market, though he also acknowledges the market process eventually adjusts the loan rate to the broader market rate of interest.  In the Austrian view, determinants of the broader market interest rate are not exhausted by the determinants of the loan rate in the loanable funds market (Rothbard 1970:321-323), although the slope of the hypotenuse of the Hayekian triangle reflects the interest rate determined in the loanable funds market (Garrison 2001:50).  The value of inputs is a derived demand determined by the price an entrepreneur expects to command for output at the end of a production stage[2].  This expected price is discounted over the duration of the production stage (Garrison 1985:170; 2001:46). 


Productive resources have differing degrees of substitutability and complementarity (Garrison 1985:168; 2001:49).  Austrian business cycle theory emphasizes the inflexibility imposed by the high cost of reallocating installed physical capital.  It is important to realize that similar kinds of inflexibility and high adjustment costs can come from other resources, particularly labor.  Workers often resist seeking employment outside preferred venues.  Because this source of high unemployment results from high adjustment costs which frustrate resource allocation and adjustment of the production structure, rather than from real or nominal wage or price stickyness, this potential cause of recession, though labor-based, should be recognized as Austrian rather than Keynesian.   Mulligan (2002) presents evidence that labor employment is reallocated over the business cycle in a manner similar to that predicted by Austrian business cycle theory for the physical capital it complements.


When changing conditions call for entrepreneurial managers to revise their production plans, they face the constraint imposed by the pre-existing capital structure[3].  Future entrepreneurial plans are always potentially constrained by the desirability of making some use of the existing capital and goods in process, though in extreme cases it may be abandoned completely.  This is more likely to be the case the closer capital equipment is to the end of its usable life, but then the adjustment cost is the whole value of the discarded equipment.  Much production which occurs during business expansions is simply wasted, because given people's time preference, this output was never desired anyway.


In the Austrian theory of the business cycle, policy-induced monetary or credit expansion discoordinates the Hayekian production structure in an unsustainable manner, creating the boom before the bust.  Expansion is manifested in an artificial oversupply of investable resources (often called loanable funds, see Garrison 2001:36), signaled by a below-market interest rate.  As a practical matter, it is much easier to conclude either that (a) money or credit supplies have increased, or that (b) commercial and industrial lending or private domestic investment spending have increased, than to assert that a particular prevailing interest rate is lower than what the market would dictate in the absence of the overexpansion. Austrian capital theory does not rely on Fisher's (1896) distinction between real and nominal interest rates or the distinction between anticipated and unanticipated changes in the general price level, instead emphasizing a distinction between preference-based changes in interest rates and policy-induced changes. 


The unsustainable expansion is most often considered in terms of an overabundance of physical capital which is installed in increasingly earlier stages of production.  As the expansionary intervention supplies more investable resources, and does so at a depressed interest rate, entrepreneurial managers fund lower and lower yielding investment projects in earlier production stages more remote in time from final users, simultaneously taking advantage of the lower loan interest rate and the newly more abundant supply of investable resources. 


However, the business cycle can also be described in terms of how expansionary policy forces an overcommitment on the part of entrepreneurial planners to activities which are both more capital-intensive and time-intensive, and thus, lower-yielding.  Such production plans cannot be expanded or sustained indefinitely, even if the interest rate continues to fall, because the nominal interest rate cannot fall below zero.  Planners surrender flexibility whenever they commit liquid financial capital to a particular production plan.  If business conditions change, production plans can not be completed as originally anticipated. The removal of flexibility on the part of the entrepreneurs can be though of as the proximate cause of the business cycle.


The production structure simultaneously extends average production time, and attempts to increase the amount of output supplied to consumers, who save less in response to the lower interest rate.  Hayek (1935:137) describes this concave "triangle" as curvilinear.  In earlier stages of production, more productive activity occurs, but with a lower rate of return to compete with the low interest rate.  In the latest stages of production, high rates of return are necessary in spite of the low interest rate, because the low interest rate influences consumers to demand more final output.  Resources are allocated out of middle stages of production into earlier and later stages, forming the "curvilinear" triangle.  But middle stages of production serve the essential function of connecting the early and late stages.  Because the early and late stages overexpand while middle stages atropy, there is no way to move the full volume of early stage goods-in-process through the middle stage bottleneck, to the late stages where consumers are clamoring for more output.  Expansionary policy locks entrepreneurs into production plans which are specific courses of action the same policy renders unfeasible.  Hülsmann (2001) particularly emphasizes that this overinvestment-overconsumption boom, which everyone applauds as an era of blessed prosperity, is better understood as a period of waste.  Scarce resources are committed to a production structure which cannot supply as much output over the long run as the sustainable preinflation, preexpansion production structure.


Lower interest rates reward entrepreneurs and firms which exploit most fully the most roundabout, capital-intensive production activities.  These plans can not prove profitable in the long run, unless the low interest rate persists indefinitely, that is, unless the lower interest rate is due to a permanent lowering of the general rate of time preference.


The Austrian business cycle focuses on intertemporal production plans because heterogeneous, multispecific factors must be coordinated in an intricate and deterministic way to yield consumable output.  All factors of production should be regarded as inherently heterogeneous.  Even two otherwise identical piles of coal of the same type and grade, take on a heterogeneous character if one is located in North Carolina and the other in Korea.  Transportation costs must be expended to render the two resources more truly homogeneous.  Even if the two piles were located contiguously, their consumption or use in production must necessarily be separated temporally, if not spatially.  Coal located in the interior of a pile can not be used as soon as coal located on top.


a. Say's Law and the Austrian Business Cycle

Conventionally rendered as "supply creates its own demand," Say's Law asserts that satisfying the wants of others enables us to earn the income we need to satisfy our own wants.  Prior to Keynes (1936), Say's Law was interpreted as asserting the impossibility of a general overproduction.  If producers supplied more than what consumers desired, or if they produced the wrong items, produced output would go unbought, signaling to the producers to produce less.  Keynes (1936:26) argued that Say's Law systematically broke down during the Great Depression.  More had been produced than people were willing to buy.  Aggregate demand had collapsed, lowering prices, and making it impossible for private industry to employ enough of the work force at reasonable pre-depression wages.  With so many people out of work, there was a significant decrease in demand for output, preventing business firms from employing enough people in a vicious cycle. 


In Keynes's view, private industry had supplied too much, and it could no longer create enough demand for this much output.  It is significant that Keynes was unable to explain why the economy should ever overproduce, beyond claiming it was just an inevitable shortcoming of capitalist organization.  His argument was that this was a natural instability of private economies, and he felt government intervention was warranted to counter it.   As Keynes saw it, the only alternative to intervention was outright socialism.


From the perspective of Austrian business cycle theory, it is easy to see that overproduction did occur in the late twenties, and also easy to see why.  Government and Federal Reserve System policy was to expand the money supply, getting commercial banks to loan out more than they held in deposits.  This expanded the supply of goods and services, increasing the demand for labor and other resources, and lowering the unemployment rate.  The expansion was unsustainable because it was unsupported by real savings.  When the Federal Reserve System finally tightened the money supply in the late 1920s, the economy collapsed as banks called in business loans.  Businesses were forced to cancel planned expansion activities.  Throughout the depression, supply of and demand for output were both lower than their pre-depression levels (Rothbard 1962).


Austrian business cycle theory can be understood as an explication of Say's Law.  This is most obvious in a barter economy where the demand for any commodity is identical to the supply of all other commodities.  In a monetary economy, when consumers demand a good, they are supplying money, which they receive from other demanders in exchange for the supply of other goods or resources (Hutt 1974, Johnson 2001, Salerno 2001).  Entrepreneurs compete to best satisfy consumer wants and gain cost advantage by making the best use of available resources.  Recessions occur when entrepreneurs are given too cheap access to too plentiful credit facilities.  Entrepreneurs respond by expanding production and employing more capital in more roundabout and time-consuming, and thus lower-yielding, productive activities.  Entrepreneurs demand more producers' goods in early stages of production, even as they attempt to supply more consumers' goods in later stages.  Consumer demand rises because saving falls with the lower interest rate.  The derived demand for labor is discounted based on how remote the labor is from final output (Van den Hauwe 2001).  Unless the production possibilities set expands, the economy cannot simultaneously produce more producers' goods and more consumers' goods.  Correction becomes inevitable.


b.  Installed v. Financial Capital in Entrepreneurial Plans:

Bischoff’s Putty-clay Model

Bischoff (1970) presents a valuable distinction between uninvested financial capital and installed physical capital: the "putty-clay" model.  In his formulation, "putty" capital is uninvested saving which helps clear the loanable funds market.  "Clay" capital has already been installed, and is expected to yield a definite return in currently-operating entrepreneurial plans[4].  This expected return must be at least as high as the return on financial assets, such as government bonds, available to entrepreneurs when they formed their production plans.  The actual return on installed capital may be lower, as expectations may be disappointed.


When interest rates change, this impacts entrepreneurial decisions about whether and where to invest "putty" capital.  "Clay" capital, which is already installed, may be abandoned completely, or may be used exactly as called for in the original production plan.  Most commonly, however, "clay" capital is used in modified production plans, which attempt to extract as high a return as possible (Garrison 2001:74).  The available "clay" capital was intended for a different production plan, predicated on a different interest rate, for a given maturity corresponding to the useful life of the installed capital.


In Keynesian terms, there is a liquidity constraint on "clay" capital, in contrast to uninvested "putty" capital.  Investors would take funds directly out of installed capital and invest these funds in higher-yielding government bonds or other financial assets if they could, but these funds are tied up in illiquid physical assets, or in term leases on physical assets.  These physical assets may be sold but cannot command as high a price once their productive yield becomes less competitive.  Lachmann (1956) recognized that installed "clay" capital is inherently multispecific and heterogeneous. 


It is less obvious that multispecificity and heterogeneity are also shared to some extent by uninstalled financial or "putty" capital.  This insight is the basis for the segmented markets (Culbertson 1957) and preferred habitat (Modigliani and Sutch 1966) theories of term structure, the relationship between average annual return and the time to maturity at any point in time (Thomas 1997:138-154; Van Horne 1998:83-100).  In the more basic pure expectations theory (Fisher 1896; Lutz 1940) and liquidity premium theory (Hicks 1946:146-147) different maturities are perfect substitutes, thus supply of and demand for different maturities of investable assets-loanable funds have infinite elasticity of substitution. 


Under the pure expectations theory, arbitrage ensures that only expectations about future interest rates enables financial assets of different maturities to have different yields.  Under the liquidity premium theory, in addition to expectations, it is recognized that individual's desire for liquidity means lenders will demand, and borrowers be willing to pay, a liquidity premium for longer maturities, partly to offset higher default risk (Fisher 1959).  The segmented markets theory treats different maturities as having zero elasticities of substitution, and the more realistic preferred habitat theory assumes substitution elasticities across maturities are low, but that if one maturity offers a higher yield than others, arbitrage across maturities would drive away savings and attract investment demand, until the yield inequality was minimized.  The market process consists of entrepreneurial planners effecting adjustment toward a dynamic equilibrium they continuously redefine.  The prevailing term structure of interest rates determines resource allocation among early, middle, or late stages of production, in accordance with consumers' time preference and available investment alternatives.


c.  Entrepreneurial Behavior in Business Firms

Market order evolves spontaneously (Hayek 1973:39) and because firms are intelligently-designed entities, it is difficult to place the firm within the market order (Khalil 1995, 1997a, 1997b).  Coase (1937, 1988) advanced the thesis that production is generally organized in firms to minimize transactions costs which would otherwise prevent many exchanges and productive activities.  This assertion cannot be attacked on its face, but this is not all firms accomplish.  An extensive management literature has emerged on entrepreneurial planning within firms (Pondy 1970; Pfeffer and Salancik 1978; Hannan and Freeman 1984; Levinthal 1994; Lombardo and Mulligan 2003).  It seems clear that the Austrian school also offers additional insight into why production is organized in firms.  Firms provide an institutional context for entrepreneurial discovery (Kirzner 1973, 1979, 1985), facilitating the use of relevant knowledge and information (Potts 2001) and the coordination of the production process (Yu 1999).  


Because Austrian business cycle theory is built on the concept of production or capital structure, the role entrepreneurial managers play in adjusting and maintaining the production structure connects Austrian macroeconomics with Austrian microeconomics.  Production structure is central to the Austrian theory of the firm (Dulbecco and Garrouste 1999), thus grounding Austrian business cycle theory firmly on microeconomic foundations.  Baetjer (2000) notes that the need to coordinate production through the capital structure is ongoing and omnipresent due to the frequent arrival of new knowledge, which generally requires the production structure be changed. 


Baetjer emphasizes that capital equipment is useless if workers do not know how to use it, and if complementary capital is not available, e.g., a locomotive cannot be operated by a lay person, and cannot run without tracks.  Cochran (2001:22) makes a similar point.  Maintaining the production structure is a dynamic, disequilibrium process, as described by Lewin and Phelan (2000:68).  Augier and Augier (2003) develop a set of formal models to explore the implications of regarding stages of the production the production process as endogenous, that is, determined by entrepreneurs responding to incentives within the economy.


3.  Qualitiative Applications and Earlier Empirics

Austrian business cycle theory is unmatched in offering persuasive qualitative explanations of historic business cycles.  This fact by itself makes a powerful case for the Austrian school, which should be accepted as the dominant macroeconomic policy paradigm. Curiously, the Austrian business cycle was once the leading theory (Haberler 1937).  More recently the Austrian theory is often dismissed (e.g., Friedman 1969:261-284, 1993; Hummel 1979; Yeager 1986:378; Tullock 1987, 1989; Cowen 1997; Wagner 2000) or simply ignored.  In response, an Austrian literature of defense, apology, and counterattack has developed (Salerno 1989; Garrison 1996, 2001; Cwik 1998; Block 2001).  Although their analysis of investment as a driver of recession owes little to the Austrian school, Chari, Kehoe, and McGrattan (2002) conclude the Great Depression was caused by labor market rigidities, and that investment frictions played a minor role. Holcombe (2001) discusses some reasons why Austrian macroeconomics is undervalued by the neoclassical and Keynesian mainstream.


Rothbard's (1963) monumental study of the inflationary roots of the Great Depression persuasively argues that credit expansion created an unsustainable boom in the 1920s, and that government policy frustrated the efforts of economic agents to liquidate inefficient capital, resulting in a protracted secondary contraction, thus transforming what would have been a routine recession into the Great Depression by preventing prompt liquidation of overinvestment.  Valuable resources which could have been used for more productive purposes, and for output more urgently desired by consumers, instead were tied up in fruitless and counterproductive attempts to maintain labor employment in the same industries which had already overexpanded through the malinvestment boom.  Focusing on unorthodox and rarely examined monetary aggregates, Rothbard shows that inflation and credit expansion continued sporadically well into the 1930s, effectively preventing any general liquidation of malinvested capital.  Rather than facilitate liquidating malinvestment, easy credit policies generated further opportunities for malinvestment.  The misallocation of productive resources was further exacerbated by governmental efforts to restore and maintain artificially high prices through cartelization and price controls. 


Table 1

Competing Views of the Great Depression




Liquidity trap created once nominal interest rates became low enough; bank demand for excess reserves became perfectly elastic.  Monetary base doubled between 1929-38: monetary policy was expansionary, but excess reserves accumulated in banks.  Demand for loans depressed due to unfavorable business outlook.  Banks did not buy any but the shortest-term securities because nominal yields were so low.

Real interest rates extremely high due to price deflation: e.g., CPI fell 10% in 1931 and 1932,  indicating contractionary policy.  Growth in monetary base mostly attributable to currency held by public, unavailable for lending, rather than bank reserves.  "Flight to quality" greatly increased demand for short-term Treasury securities, depressing their yield.  Fed tightened discount lending policy in 1931, and doubled the reserve requirement between 1936-37, triggering a secondary recession.

Expansionary monetary policy depressed interest rates and created an unsustainable investment boom throughout the late 1920s.  Monetary policy was intermittently expansionary and contractionary throughout the 1930s.  Government intervention initiated under the Hoover administration between 1930-32 delayed liquidation of malinvested capital.  Price fixing, fiscal stimulus, and monetary activism (intermittently expansionary and contractionary), continued and extended under the Roosevelt administration, prevented liquidation of malinvested capital, delaying liquidation of malivested capital, prolonging the Depression.

Keynes 1936, Hicks 1939, Modigliani 1944

Friedman and Schwartz 1963: 411-419

Rothbard 1962, Garrison 2001


This view contrasts markedly with Friedman and Schwartz's (1963) conclusion that the secondary contraction was caused by the Federal Reserve System's failure to provide enough liquidity (Table 1).  Using the standard monetary aggregate that ultimately emerged as M1, Friedman and Schwartz find that the main problem during the depression was that the money supply shrank, even though the monetary base grew.  Table 1 summarizes some of the evidence cited by Keynesian, monetarist, and Austrian authors.  It is difficult to avoid the conclusion that the Austrian explanation is the most encompassing, even though Austrian business cycle theory focuses on the unsustainable expansion which precedes a recession[5].  The monetarists are simultaneously to be applauded for introducing the first evidence of contractionary policy over three decades after the start of the recession, as well as to be scolded for selectively ignoring very real evidence of expansionary policy, which remains irrefutable.



The Austrian perspective can be interpreted as intermediate between the Keynesian, emphasizing a liquidity trap which made expansionary monetary policy ineffective, and the monetarist, which criticizes the Fed for unwittingly implementing a contractionary policy.  The Austrian school blames the expansionary policy of the 1920s for the onset of the Depression, and active government and central bank policy for transforming what would have been a routine recession into a decade-long ordeal.  The Austrian school goes beyond the monetarist school in emphasizing the real discoordination and resource misallocation forced by government and central bank activism, resulting in persistent and abnormally high unemployment. 


Because he was not an academic, Harwood (1932) focused only on the unsustainable aspects of inflation, not on how it created an overextended production structure.  Economic historian William Graham Sumner (1891) also recognized that inflation precipitated economic downturns.  Harwood's theory of the business cycle was that the root cause was any excess of investment spending over saving.  Such an imbalance can only be introduced through systematic expansion of the money supply, which allows banks to lend funds for business investment in excess of the savings they hold on deposit.  He argued that the amount might be small initially, but would necessarily grow over time, as producers' goods face increased demand, bidding up their price. 


Harwood agreed with Mises and Hayek that unsustainable expansion comes about primarily because the interest rate is kept artificially low due to the oversupply of cheap credit, and businesses take advantage of the attractive low borrowing rate to finance expansion of production facilities. He largely disregarded the impact of localized distortions, recognizing that they occur, but arguing that their impact distorting the allocation of productive resources must be negligible.  This is a major difference between Harwood and Mises and Hayek. 


In Harwood's view, as soon as investment spending exceeds saving, businesses that sell producer's goods start expanding to satisfy increased demand for productive assets.  The increased spending results in increased income to households and workers, meaning that the increased demand is for consumption goods as well as investment goods.  Harwood's point is that this leads to a general increase in business activity to satisfy what businesspeople perceive as increased demand for goods and services.  Though he accepted the Mises's and Hayek's views that investment and employment expand fastest and farthest in the industries most directly affected by the additional investment spending, he felt this was generally less important than the fact the increase in spending is quickly diffused throughout the consumption-goods-producing sector. 


O'Driscoll and Shenoy (1976) present an account of the stagflation of the 1970s.  They note that credit expansion increases nominal demand at the point the newly-created money is injected, distorting the price vector and the allocation of resources, especially of capital which cannot be easily reallocated.  Credit expansion always increases consumption expenditures because any new money results in increased nominal income to some households.  Firms engaging in production most remote from consumption find resource prices bid up, and resources bid away, by firms selling directly to consumers.  Unemployment starts in these firms remote from final consumption even as prices continue to be bid up by continued injections of cheap credit.  Garrison (2001:145-164), in the most important contribution to Austrian macroeconomics since 1949, also provides convincing accounts of both the Great Depression and the stagflation of the 1970s using the Austrian model.


Cwik (1998) uses the Austrian theory to analyze the Gulf crisis recession of 1990.  Carilli and Dempster (2001) argue that Austrian business cycle theory places undue reliance on economic agents misperceiving credit expansion as a real increase in loanable funds.  They suggest that even if rational agents correctly anticipate inflation, agents maximize profits under uncertainty by taking advantage of the market interest rate whenever it falls below the underlying rate of time preference.  Keeler (2001) used standardized quarterly data for eight U.S. business cycles, finding monetary shocks did cause cycles which were propagated through relative price changes, including nominal interest rates. 


Powell's (2002) account of the Japanese recession of the 1990s is especially noteworthy because he focuses on exactly how expansionary monetary and fiscal policy recommended to spur recovery, actually lengthened and deepened Japan's recession.  His conclusion is that monetarist policy prescriptions proved only marginally less ineffective than Keynesian ones.  As with the Great Depression, poor policy prescriptions transformed what should have been a routine recession into a decade-long ordeal.  Mulligan (2002) used sectoral labor data as indicators of resource allocation among industrial sectors.  Resources are reallocated among early, middle, and late stages of production in response to changes in nominal interest rates, as Austrian business cycle theory predicts.  Callahan and Garrison (2003) explain the 1990 technology boom and subsequent recession of 2001-2002 in terms of Austrian business cycle theory.  They are able to point to specific Cantillon effects created when excess liquidity was injected into localized markets, showing how markets temporarily inflated prices for computer programmers and web developers, real estate in certain cities, and technology stocks. Cochrane, Call, and Glahe (2003) argue that the location and timing of credit injection are especially critical in determining where and how far the production structure will overexpand, and what will be the nature and timing of the inevitable collapse.


In marked contrast to orthodox neoclassical and Keynesian accounts of the business cycle, Austrian business cycle theory presents a consistent and coherent explanation of the causes and propagation mechanisms of the business cycle.  Though more typically qualitative than quantitative, the explanatory successes of Austrian business cycle theory have proved robust over an impressive time period and range of specific applications.  This remarkable success makes it even more puzzling that Austrian business cycle theory has not been enthusiastically embraced by non-Austrians, and that it has yet to emerge as the dominant macroeconomic policy paradigm.


4. The New Keynesian Small Menu Cost Theory of the Business Cycle

The New Keynesian small menu cost model of the business cycle is an attempt to explain the business cycle in terms of resistance to small changes in prices.  Price stickyness results in large changes in real output, employment, and consumer welfare.  When all factors are considered heterogeneous, the critical contribution of the entrepreneurial planner can be appreciated.  Entrepreneurs are not resistant to changing small menu prices merely because of the accounting cost of doing so, but because of the cost of marshalling information against the uncertainty of future market conditions and the cost incurred when their decision goes wrong.


The small menu cost model attributes the inability of entrepreneurs to reallocate resources to the false signals given by market prices which are temporarily slightly out of equilibrium due to price-setters' desire to avoid costs associated with changing prices.  Thus the allocation realized by the market is necessarily suboptimal, resulting in large swings in real output and employment.


It seems much more satisfactory to view the underlying inflexibility in resource allocation to a more general resistance on the part of entrepreneurs to altering their production plans, an activity which occasionally becomes imperative, but often can be avoided as particularly risky, costly, and undesirable.  It seems more promising to incorporate behavioral inertia into models of entrepreneurial action, an element of resistance to revising production plans.  Entrepreneurs hope for an environment where their plans can be left in place as long as possible.


Thus a reformulated Austrian business cycle theory emphasizes costs associated with changing production plans, rather than merely with costs associated with changing prices or capital allocation alone.  The production plan formulated by an entrepreneur specifies the quantity and types of resources to be combined, in a definite manner, given expected resource and output prices, to yield a certain amount of a definite output of a certain expected value.  Many characteristics of such a plan would frustrate attempts at too-frequent revision, not only resource prices.  Each characteristic of such a plan imposes certain difficulties and costs, and thus contributes to large fluctuations in output and employment, along with small menu costs.  The small menu cost model serves as one example of how these fluctuations can arise, but it seems clear that it is only one cause among many and that Austrian capital theory offers a more general, and consequently more satisfactory, explanation of the business cycle.


The small menu cost model (Rotemberg 1987; but see also Rotemberg 1982; Akerloff and Yellen 1985; Mankiw 1985; Ball and Romer 1987, 1990; Ball, Mankiw, and Romer 1988; McCafferty 1990: 453-463) is based on the Taylor series expansion[6] of the profit function for a representative firm in a monopolistically competitive market.  Firm i should refrain from changing output prices as long as the (economy-wide with J identical firms) difference in profits gained through changing prices is smaller than the cost of changing prices, the menu cost c,

D ≡ Jpi1 - Jpi0  < c,

where pi1 is firm i's profit if it charges the new price and all other firms continue to charge the old output price P0, and pi0 is firm i's profit if it refrains from changing price, along with all its competitors who continue to charge P0.  The result



q1/(1 - β)

1 - (1 - q)2

(P0 - P*)2,


2(1 - q)


an expression for the difference in profits divided by the flexible-price equilibrium price level P*, contains no first-order expressions in (P0 - P*), the change in prices.  It is observed that if D < c, then not changing output prices will be optimal for all firms, and since D is proportional to (P0 - P*)2, very low menu costs may still be compatible with the condition D < c.


It is also demonstrated that output levels Yi = Ci always lie on the demand curves

JCi = (Pi/P)1/(1 - β)(M/P)

in this monopolistically competitive market[7].  Since Pi = P* for all i, and P* solves M = P*q1/(1 - β), the fixed-price equilibrium output level is

Y0 = q1/(1 - β)(P*/P0),

and the difference between the fixed-price and flexible-price equilibrium output levels is given by


Y0 - Y*


q1/(1 - β)

(P* - P0).


This expression demonstrates that changes in output levels due to nominal price rigidity, and therefore in employment levels, can be first order in (P* - P0) while the underlying menu costs may only be second order (proportional to (P* - P0)2).  Rotemberg's conclusion was that his argument demonstrated the possibility that small menu costs, which plausibly delay producers from adjusting prices toward equilibrium and prevent markets from clearing, result in much larger swings in real output and employment.


Evidence for small menu costs has not been overwhelming.  The key result is that nominal rigidities may be small and still cause business cycles; it may well be that the rigidities are too small to perceive.  Cecchetti (1986) found evidence of rigid newsstand prices for magazines.  Rotemberg (1982) suggests firms that change prices too frequently may be viewed by their customers as erratic and face reduced sales.  Rotemberg's small menu cost model is closely related to Akerloff and Yellen's (1985) model demonstrating second-order departures from optimal equilibria at the individual level can result in first-order fluctuations in macroeconomic aggregates.  A closely related class of New Keynesian business cycle models, the efficiency wage models, base their results on wage rigidities rather than output price rigidities, exemplified by Yellen (1984).


5. An Austrian Critique of the Small Menu Cost Model

Rotemberg's implicit assumption is that menu costs are the only barrier, or at least the most important barrier, to perfect and instantaneous market clearing.  The Austrian view is that all prices, or nearly all prices, are nearly always disequilibrium prices.  Prices are either held steady in between experimental entrepreneurial adjustments, or are in the process of being adjusted experimentally.  Production plan adjustments aim at increasing profits but are not necessarily always successful.  In between experiments, entrepreneurs are resistant to changing prices because they are deterred by the cost of getting the decision wrong, although they also understand that the current price is also wrong in some sense, and higher profits could nearly always be earned by changing to the currently unknown, currently correct price.  This Austrian understanding accords very well with the New Keynesian concept of small menu costs.  The justification for nominal rigidities is less important than the conclusion they are justified.


However, the Austrian view of the entrepreneur's price setting decision is that it is only one element the entrepreneur carries out in managing a production plan.  The Hayekian production plan, which is subject to constant revision, includes current and expected future output and input prices, selection of technology, input and output quantities, and resource bills.  Because production takes place over time, inevitable changes in market data change the most desirable outcome of the production process, even as output is being produced.  Whenever the interest rate changes, optimal allocations of capital in each stage of production change, but production plans are more inflexible.  Each stage of production is filled with half-baked cakes (Kirzner 1996:37-41).  If there were no adjustment costs to be borne, the production structure could instantaneously adapt to changed market conditions, but usually it is too wasteful to completely abandon unfinished goods-in-process and already-installed capital equipment.  However, as the New Keynesian small menu cost model emphasizes, resistance to making small price changes results in larger-order fluctuations in employment and output. 


Because capital equipment is long-lived and its cost must be amortized, the relevant choice an entrepreneur faces when new market information is revealed is best understood not so much in terms of what is the best production structure newly installed from scratch, but what is the best use of already-installed capital.  Thus, the use of capital equipment, and other difficult to reallocate resources, such as human capital, imposes an additional set of inflexibilities on the market beyond nominal rigidities.  Although nominal rigidities clearly impose inflexibility on entrepreneurial attempts to respond to changing conditions, nominal rigidities are nested within a given production structure.  Thus Austrian business cycle theory can be considered as subsuming the New Keynesian small menu cost theory of the business cycle, although there should be a substantial debate between Austrians and New Keynesians over which plays a more important role in driving the business cycle, nominal rigidities or rigidities in intertemporal resource allocation, that is, in the capital structure.


The greatest shortcoming of the small menu cost model seems to be the lack of compelling justification for connecting nominal rigidities in clusters of errors, which must occur randomly fairly frequently, with the non-periodic business cycle.  Individual entrepreneurial errors are common, occurring both frequently and randomly (Rothbard 1997:73; Mueller 2001:13), although in the small menu cost model, nominal rigidities are not errors in the local sense, only in the global sense.  Since postwar recessions have occurred approximately every ten years on average, it seems fair to ask, that if recessions are due to nominal rigidities, why recessions are not more frequent.  If the economy experiences a recession simply because it is optimal for firms to keep using old menus since it costs a non-negligible sum to replace them, it seems reasonable to ask why recessions occur less frequently than once every two weeks to six months. 


Apart from the issue of how frequently the models predict recessions, is the issue of what coordinates the discoordination throughout the economy.  Schumpeter's (1911, 1939) technology-based business cycle model faces the same difficulty.  In the small menu cost model, firms face nominal rigidities, and periodically overcome them, seemingly at random.  It may be that the business cycles are in fact due to nominal rigidities, but do not occur more frequently, because it calls for a fairly extraordinary confluence of random events to ensure a sizable number of firms are simultaneously failing to adjust prices, and perhaps this only happens randomly about once every ten years.  Hülsmann (2001:36-39), in recognizing the importance error clusters, criticizes Garrison's (2001) modeling of them.  Hülsmann emphasizes that the boom, which appears to be a period of growth and prosperity, is actually a period of wasting scarce resources.  People's belief in the reality of their prosperity was as erroneous in 1999 as it was 1929. 


In the New Keynesian view, recessions are inevitable and occur at random.  Sechrest (2001:73-75) argues that monetarism provides a more plausible explanation of the timing of recessions than the small menu cost theory, but it also fails to explain why it takes so long for the economy to recover.  In Austrian business cycle theory it is clear that the interest rate coordinates the economy's production structure, and credit expansion causes a general overexpansion of production and economic activity.  Recessions are not inevitable, but result from poor monetary policy.  Recessions last six months to two years because that is how long it takes for entrepreneurs to reallocate resources in a sustainable production structure, in the absence of continued central bank intervention delaying or preventing liquidation of capital misallocated during the wasteful expansion.


6.  An Austrian Model of Inertia in the Production Structure

An Austrian reinterpretation of the Rotemberg (1987) model is developed below.  Entrepreneurs seek to maximize the profit function incorporating a heterogeneous-capital-using technology (Lachmann 1956), which might be represented in Cobb-Douglas form[8] as







i = 1

Each entrepreneur seeks to maximize the subjective profit function









pjitljit ,



i,j = 1

i,j = 1

subject to the technology selected by the entrepreneur and the expected vector of prices, potentially revised even during the production process.  In each period t, entrepreneurs purchase basic and intermediate inputs to transform into lower-order intermediate inputs and final output in period t+1.


Rotemberg's profit-differential function now takes on a new and broader interpretation.  Firm i should refrain from changing its production plan as long as the difference in profits gained through changing the plan is smaller than the adjustment cost a, analogous to, and including, the menu cost c,

D pi1 - pi0 < c < a.

Clearly this adjustment cost a, since it includes the menu cost c, must always be at least as great as c, and often will be much greater.  Thus the Austrian interpretation of the small menu cost model automatically imposes a higher threshold which must be exceeded before entrepreneurs react, suggesting a less flexible, less adaptive economy, an important advantage to the Austrian interpretation.  The Js drop out because each entrepreneur's profit function is unique and while there might be a typical entrepreneur, there are no identical representative agents. The production plan at any time t is predicated on an information set[9] F, which incorporates the production plan itself.  In a zero-adjustment-cost environment, it would always be optimal and costless to adjust the production structure whenever new information becomes available.  In the real world, however, entrepreneurs face information costs whenever they confront, develop, evaluate, and respond to new information. 


In addition, entrepreneurs face the cost of discarding old installed physical capital, human capital, and goods-in-process embodied in the old production structure, as well as discarding outdated menus.  Because the production structure cannot be constantly readjusted without incurring significant cost, once entrepreneurs have implemented a production plan, they may resist revising it, and may even resist alertness to new information which calls for revising a production plan once it has been implemented (Kirzner 1973:35, 64-68, 1992:26-28; Hannan and Freeman 1984).  It seems to be in the nature of production planning that entrepreneurs are always engaged in adjusting them and reallocating resources, but adjustment costs and the desire to make use of already-installed physical capital and already-produced goods-in-process, ensure the production plan is never fully adjusted to the optimal, zero-adjustment-cost production structure. 


It is attractive to think of the individual profit states and the difference in expected future profits which can be realized by adjusting the production structure as being a function of the generic information setF which includes the production technology relating inputs to outputs in each stage of production, and input and output prices, both present and those expected to prevail in the future.  One essential component of the information set is the current interest rate, and expected future interest rates.  This will be a key element in coordinating the behavior of disparate firms which are otherwise unlikely to act in concert.


In each decision period, entrepreneurs assess whether to revise the production structure.  To obtain Rotemberg's result, expand a generalized expression for D aroundF0 = F*, whereF0 represents the original information set which was the basis for the prevailing production structure, andF* represents a new information set implying a new and different zero-adjustment-cost profit-maximizing production structure. The second-order Taylor series expansion of D aroundF0 = F* is given by






F0 = F*

(F0 - F*)




F0 = F*

(F0 - F*)2.




The first derivative of D with respect toF0can be written as









or equivalently in terms of partial derivatives as














in which it can be seen that the first right-hand-side term is identically equal to zero.  This is because under the general assumption of expanding the Taylor series aroundF0 = F*, the partial derivative of each firm's (or each entrepreneur's) information set Fi is identical to the original starting information set F0 = F*, thus the first derivative dFi/dF0, is identically equal to zero, essentially by assumption.


The analogous expression for the second-order Taylor-series expansion, here for changes in the basic information set, can now be expressed as



q1/(1 - β)

1 - (1 - q)2

(F0 - F*)2.

2(1 - q)


This expression for the minimum change in the production structure, or for production plan revision, contains no first-order expressions in (F0 - F*), the information set revision.  It is observed that if D < a, then not changing production plans will be optimal for all entrepreneurs, and since D is proportional to (F0 - F*)2, very low adjustment costs may still be compatible with the condition D < a.


Since output price is one component of the information setF, Rotemberg's original conclusion still holds. Entrepreneurial hesitancy against instantaneous and error-free adjustment in response to new information can prevent markets from clearing, and can result in much larger swings in real output and employment.


Including economy-wide interest rates in the information set F enables Rotemberg's model to plausibly face an economy-wide shock, general policy-induced credit expansion including a lowered real interest rate, resulting in an economy-wide unsustainable expansion, and consequent correction.  Embodying past information sets in a production structure characterized by inertia, an essential feature contributed by Austrian business cycle theory, enables the Rotemberg model to plausibly explain why recessions occur approximately once every ten years rather than once every two weeks.


Comparing the two theories in this way demonstrates the Austrian theory at least as good as small menu cost theory, if not better, perhaps more importantly, that it is encompasses the New Keynesian theory, and that it more plausibly explains why recessions occur when they do.  The biggest difference between the two theories is that in the small menu cost model, recessions are inevitable and occur at random.  In the Austrian model, recessions are avoidable and are caused by expansionary monetary or fiscal policy.


7.  Conclusion

Interest rates facilitate intertemporal coordination of productive resources by clearing the loanable funds market (Garrison 1986:440; 2001:39).  In this regard disequilibrium interest rates play the same role as prices in signaling opportunities for entrepreneurial discovery (Kirzner 1984a:146; 1984b:160-161; 1997), and individual entrepreneurs respond by maintaining the production structure, that is, they adjust it by reallocating resources.


An Austrian critique and interpretation of the New Keynesian small menu cost model of the business cycle has been presented and discussed.  The Austrian generalization of the small menu cost model reveals that Austrian capital theory's multispecific-capital-using economy reduces to a nominal rigidities model when capital is removed.  Austrian business cycle theory is proposed as an encompassing model of the business cycle, in which cycles arise due to resistances to instantaneous change, which can arise from many sources.  The Austrian interpretation of the small menu cost model addresses several problems, including how rigidities are coordinated across heterogeneous agents.




Akerloff, George A.; and Yellen, Janet L. (1985). A Near-rational Model of the Business Cycle, with Price and Wage Inertia. Quarterly Journal of Economics 100(supplement): 823-838.


Anderson, Benjamin M. ([1949] 1979). Economics and the Public Welfare: a Financial and Economic History of the United States, 1914-46. New York: Van Nostrand; (2nd ed.) Indianapolis: Liberty Press.


Augier, José; and Augier, Laurent (2003). Production Period and Cycles: Several Interpretations in a Neo-Austrian Economic Perspective. Review of Austrian Economics 16(2/3): 205-230.


Baetjer, Howard (2000). Capital as Embodied Knowledge: Some Implications for the Theory of Economic Growth. Review of Austrian Economics 13(2): 147-174.


Ball, Lawrence; Mankiw, N. Gregory; and Romer, David (1988). The New Keynesian Economics and the Output-Inflation Tradeoff. Brookings Papers on Economic Activity I: 1-65.


Ball, Lawrence; and Romer, David (1987). Are Prices Too Sticky? Quarterly Journal of Economics 104(3): 507-524.


Ball, Lawrence; and Romer, David (1990). Real Rigidities and the Non-neutrality of Money. Review of Economic Studies 57: 183-203.


Batra, R. N. (1974). Resource Allocation in a General Equilibrium Model of Production under Uncertainty.  Journal of Economic Theory. 8(1): 50-63.


Bischoff, Charles W. (1970). A Model of Nonresidential Construction in the United States. American Economic Review 60(2): 10-17. 


Blaug, Mark (1998). Entrepreneurship in the History of Economic Thought. Advances in Austrian Economics 5: 217-239. Stamford CT: JAI Press.


Block, Walter (2001). Yes, We Have No Chaff: a Reply to Wagner's "Austrian Cycle Theory: Saving the Wheat While Discarding the Chaff." Quarterly Journal of Austrian Economics 4(1): 63-74.


Britto, Ron (1980). Resource Allocation in a Simple, Two-Sector, Model with Production Risk. Economic Journal 90: 363-370.


Butos, William N. (2001). Garrison and the "Keynes Problem." Quarterly Journal of Austrian Economics 4(3): 5-16.


Butos, William N. (2003). Knowledge Questions: Hayek, Keynes and Beyond. Review of Austrian Economics 16(4): 291-308.


Callahan, Gene; and Garrison, Roger W. (2003). Does Austrian Business Cycle Theory Help Explain the Dot-com Boom and Bust? Quarterly Journal of Austrian Economics 6(2): 67-98.


Cantillon, Richard. (1755 [1952]). Essai sur la nature du commerce en général.  new ed., Paris: Institut national d'études Démographiques.


Carilli, Anthony M.; and Dempster, Gregory M. (2001). Expectations in Austrian Business Cycle Theory: an Application of the Prisoner's Dilemma. Review of Austrian Economics 14(4): 319-330.


Casson, Mark. (1982). The Entrepreneur: an Economic Theory, Oxford: Martin Robertson.


Casson, Mark (1995). Entrepreneurship and Business Culture, vol. 1, Aldershot: Edward Elgar.


Cechetti, Stephen (1986). The Frequency of Price Adjustments: a Study of the Newsstand Price of Magazines. Journal of Econometrics 255-274.


Chari, V.V.;  Kehoe, Patrick J.; and McGrattan, Ellen R. (2002). Accounting for the Great Depression. American Economic Review 92(2): 22-27.  Reprinted (2003) in Federal Reserve Bank of Minneapolis Quarterly Review 27(2): 2-8.


Chiang, Alpha C. ([1967] 1984). Fundamental Methods of Mathematical Economics (3rd ed.) New York: McGraw-Hill.


Coase, Ronald H. ([1937] 1988). The Nature of the Firm. Economica 4 n.s., reprinted in Coase, The Firm, the Market, and the Law.  Chicago: University of Chicago Press, pp. 33-55.


Coase, Ronald H. (1988). The Firm, the Market, and the Law.  Chicago: University of Chicago Press.


Cochran, John P. (2001). Capital-based Macroeconomics. Quarterly Journal of Austrian Economics 4(3): 17-26.


Cochran, John P.; Call, Steven T.; and Glahe, Fred R. (2003). Austrian Business Cycle Theory: Variations on a Theme. Quarterly Journal of Austrian Economics 6(1): 67-74.


Cowen, Tyler (1997). Risk and Business Cycles. London: Routledge.


Culbertson, J.M. (1957). The Term Structure of Interest Rates. Quarterly Journal of Economics 72:489-504.


Cwik, Paul (1998). The Recession of 1990: a Comment. Quarterly Journal of Austrian Economics 1(3): 85-88.


Dulbecco, Philippe; and Garrouste, Pierre (1999). Towards an Austrian Theory of the Firm. Review of Austrian Economics 12(1): 43-64.


Fisher, Irving (1896). Appreciation and Interest. Publications of the American Economic Association (New York: Macmillan) 11:23-29, 92-92.


Fisher, Lawrence (1959). Determinants of Risk Premiums on Corporate Bonds. Journal of Political Economy 78:217-237.


Friedman, Milton (1969). The Optimum Quantity of Money and Other Essays. Chicago: Aldine.


Friedman, Milton (1993). The "Plucking Model" of Business Cycle Fluctuations Revisited. Economic Inquiry 31: 171-177.


Friedman, Milton; and Schwartz, Anna J. (1963). A Monetary History of the United States 1867-1960. Princeton: Princeton University Press and NBER.


Garrison, Roger W. (1978). Austrian Macroeconomics: a Diagrammatical Exposition. In Spadaro, Louis M., (ed.), New Directions in Austrian Economics, Kansas City: Sheed Andrews & McMeel, pp. 167-204.


Garrison, Roger W. (1985). A Subjectivist Theory of a Capital-Using Economy. In O’Driscoll, G.P.; and Rizzo, M., The Economics of Time and Ignorance, New York: Routledge, pp. 160-187.


Garrison, Roger W. (1986). The Hayekian Trade Cycle Theory: a Reappraisal. Cato Journal 6(2): 437-453.


Garrison, Roger W. (1988). The Austrian Theory of the Business Cycle in Light of Modern Macroeconomics. Review of Austrian Economics 3: 3-29.


Garrison, Roger W. (1995). Equilibrium and Entrepreneurship. Advances in Austrian Economics 2: 67-78.


Garrison, Roger W. (1996). Friedman's "Plucking Model:" Comment. Economic Inquiry 34(4): 799-802.


Garrison, Roger W. (2001). Time and Money: the Macroeconomics of Capital Structure. London: Routledge.


Gellert, W.; Küstner, H.; Hellwich, M.; and Kästner, H. (eds.) (1975). The VNR Concise Encyclopedia of Mathematics, Kleine Enzykolpädie der Mathematik. New York: Van Nostrand Reinhold.


Gödel ([1931] 1962) On Formally Undecidable Propositions of Principia Mathematica and Related Systems. Meltzer, B. (trans.) New York: Basic Books, reprint, New York: Dover. Originally published as Über formal unentscheidbare Sätze der Principia Mathematica und verwandter Systeme I. Monatshefte für Mathematik und Physik 38:173-198.


Haberler, Gottfried ([1937] 1960). Prosperity and Depression: a Theoretical Analysis of Cyclical Movements (2nd ed.) Cambridge: Harvard University Press.


Hannan, M.T.; and Freeman, J.H. (1984). Structural Inertial and Organizational Change.  American Sociological Review 49: 149-164.


Harwood, E.C. ([1932] 1974). Cause and Control of the Business Cycle (10th ed.) Great Barrington MA: American Institute for Economic Research, Economic Education Bulletin 14(9).


Hayek, Friedrich A. (1931). Prices and Production. 1st edition, London: Routledge.


Hayek, Friedrich A. (1941). The Pure Theory of Capital. Chicago: University of Chicago Press.


Hayek, Friedrich A. ([1933] 1966). Monetary Theory and the Trade Cycle. New York: Augustus M. Kelley.


Hayek, Friedrich A. ([1935] 1967). Prices and Production. 2nd edition, New York: Augustus M. Kelley.


Hayek, Friedrich A. ([1939] 1969). Profits, Interest, and Investment, and Other Essays on the Theory of Industrial Fluctuations. New York: Augustus M. Kelley.


Hayek, Friedrich A. (1973). Law, Legislation, and Liberty 1, Rules and Order. Chicago: University of Chicago Press.


Henderson, James M.; and Quandt, Richard E. ([1959] 1980). Microeconomic Theory: a Mathematical Approach. (3rd ed.) New York: McGraw Hill.


Hicks, John R. ([1939] 1946). Value and Capital: an Inquiry into Some Fundamental Principles of Economic Theory, 2nd ed. Oxford: Clarendon Press.


Holcombe, Randall G. (2001). The Two Contributions of Garrison's Time and Money. Quarterly Journal of Austrian Economics 4(3): 27-32.


Hülsmann, Jörg Guido (2001). Garrisonian Macroeconomics. Quarterly Journal of Austrian Economics 4(3): 33-42.


Hummel, Jeffrey Rogers (1979). Problems with Austrian Business Cycle Theory. Reason Papers 5: 41-53.


Hutt, William H. (1974). A Rehabilitation of Say's Law. Athens: Ohio University Press.


Johnson, Ivan C. (2001). A Reappraisal of the Say's Law Controversy. Quarterly Journal of Austrian Economics 4(4): 25-54.


Keeler, James P. (2001). Empirical Evidence on the Austrian Business Cycle Theory. Review of Austrian Economics 14(4): 331-351.


Keynes, John Maynard (1936). The General Theory of Employment, Interest, and Money, London: Macmillan; New York: Harcourt Brace & Co.


Kirzner, Israel M. (1973). Competition and Entrepreneurship. Chicago: University of Chicago Press.


Kirzner, Israel M. (1979). Perception, Opportunity and Profit: Studies in the Theory of Entrepreneurship. Chicago: University of Chicago Press.


Kirzner, Israel M. (1984a). Prices, the Communication of Knowledge, and the Discovery Process. In Leube, K.R. and Zlabinger, A.H., (eds.), The Political Economy of Freedom: Essays in Honor of F.A. Hayek, Amsterdam: Philosophia Verlag, reprinted in Kirzner, The Meaning of Market Process, London: Routledge, 1992, pp. 139-151.


Kirzner, Israel M. (1984b). Economic Planning and the Knowledge Problem. Cato Journal 4(2), reprinted in Kirzner, The Meaning of Market Process, London: Routledge, 1992: pp. 152-162.


Kirzner, Israel M. (1985). Discovery and the Capitalist Process. Chicago: University of Chicago Press.


Kirzner, Israel M. (1992). The Meaning of Market Process, London: Routledge.


Kirzner, Israel M. (1997). Essays on Capital and Interest: an Austrian Perspective. Cheltenham UK: Edward Elgar.


Kirzner, Israel M. (1997). Entrepreneurial Discovery and the Competitive Market Process: An Austrian Approach. Journal of Economic Literature 35: 60-85.


Khalil, Elias L. (1995). Organizations versus Institutions. Journal of Institutional and Theoretical Economics 155(3): 445-466.


Khalil, Elias L. (1997a). Is the Firm an Individual? Cambridge Journal of Economics 21(4): 519-544.


Khalil, Elias L. (1997b). Friedrich Hayek’s Theory of Spontaneous Order: Two Problems. Constitutional Political Economy 8(4): 301-317.


Knight, Frank H. ([1921] 1965). Risk, Uncertainty and Profit. New York: Harper & Row.


Lachmann, Ludwig M. ([1956] 1978). Capital and Its Structure, London: Bell & Sons; reprinted Kansas City: Sheed Andrews and McMeel, 1978.


Levinthal, D.  (1994). Surviving Schumpeterian Environments:  An Evolutionary Perspective. In Baum, J.A.C.; and Singh, J.V. (eds.), Evolutionary Dynamics of Organizations.  New York:  Oxford University Press.


Lewin, Peter; and Phelan, Steven E. (2000). An Austrian Theory of the Firm. Review of Austrian Economics. 13(1): 59-80.


Lombardo, Gary A.; and Mulligan, Robert F. (2003). Resource Allocation: A Hayekian Paradigm for Maritime Conglomerates. Quarterly Journal of Austrian Economics 6(1): 3-21.


Lutz, F.A. (1940). The Structure of Interest Rates. Quarterly Journal of Economics 55:36-63.


Mankiw, N. Gregory (1985). Small Menu Cost and Large Business Cycle: a Macroeconomic Model of Monopoly. Quarterly Journal of Economics 100: 529-539.


McCafferty, Stephen (1990). Macroeconomic Theory. New York: Harper and Row.


Miller, Arthur (1968). The Price. New York: Viking.


Mills, D. E. (1983). Resource Allocation and Welfare with Risky Production.  Southern Economic Journal. 50:  551-559.


Mises, Ludwig E. von ([1912] 1980). The Theory of Money and Credit, Theorie des Geldes und der Umlaufsmittel.. Indianapolis: Liberty Classics.


Mises, Ludwig E. von ([1949] 1998). Human Action (5th ed.) Auburn: Ludwig von Mises Institute.


Modigliani, Franco (1944). Liquidity Preference in the Theory of Interest and Money. Econometrica 12: 45-88, reprinted in Hazlitt, Henry, (ed.), The Critics of Keynesian Economics, Princeton: Van Nostrand, 1960: pp. 132-184.


Modigliani, Franco; and Sutch, Richard (1966). Innovations in Interest Rate Policy. American Economic Review 56:178-197.


Mueller, Antony P. (2001). Financial Cycles, Business Activity, and the Stock Market. Quarterly Journal of Austrian Economics 4(1): 3-22.


Mulligan, Robert F. (2002). A Hayekian Analysis of the Term Structure of Production. Quarterly Journal of Austrian Economics 5(2): 17-33.


Mulligan, Robert F. (2003). An Empirical Examination of Austrian Business Cycle Theory.  Western Carolina University, Department of Business Computer Information Systems and Economics.


Nagel, Ernest; and Newman, James R. (1958). Gödel's Proof. New York: New York University Press.


O'Driscoll, Gerald P.; and Rizzo, Mario (1995). The Economics of Time and Ignorance, New York: Routledge.


O'Driscoll, Gerald P.; and Shenoy, Sudha R. (1976). Inflation, Recession, and Stagflation. In Dolan, Edwin G. (ed.) The Foundations of Modern Austrian Economics, Kansas City: Sheed & Ward, pp. 185-211.


Pfeffer, Jeffrey; and Salancik, Gerald R. (1978). The External Control of Organizations:  A Resource Dependence Perspective.  New York:  Harper & Row.


Pondy, Louis R. (1970). Toward a Theory of Internal Resource Allocation. In M. N. Zald (ed.) Power in Organizations.  Nashville:  Vanderbilt University Press. 


Potts, Jason (2001). Knowledge and Markets. Journal of Evolutionary Economics 11: 413-431.


Powell, Benjamin (2002). Explaining Japan's Recession. Quarterly Journal of Austrian Economics 5(2): 35-50.


Rotemberg, Julio J. (1982). Sticky Prices in the United States. Journal of Political Economy 90(6): 1187-1211.


Rotemberg, Julio J. (1987). The New Keynesian Microfoundations. NBER Macroeconomics Annual 1987. New York: NBER (pp. 69-104.)


Rothbard, Murray N. ([1962] 2000). America's Great Depression (5th ed.) Auburn: Ludwig von Mises Institute.


Rothbard, Murray N. ([1963] 2000). Man, Economy, and State, Auburn: Ludwig von Mises Institute.


Rothbard, Murray N. (1978). Austrian Definitions of the Supply of Money. In Spadaro, Louis M. (ed.) New Directions in Austrian Economics. Kansas City: Sheed Andrews & McMeel (pp. 143-156.)


Rothbard, Murray N. (1997). Economic Depressions: Their Cause and Cure. In Ebeling, Richard M. (ed.) The Austrian Theory of the Trade Cycle and Other Essays. Auburn: Ludwig von Mises Institute.


Salerno, Joseph T. (1989). Comment on Tullock's "Why Austrians are Wrong about Depressions." Review of Austrian Economics 3:141-145.


Salerno, Joseph T. (2001). Does the Concept of Secular Growth Have a Place in Capital-based Macroeconomics? Quarterly Journal of Austrian Economics 4(3): 43-62.


Say, Jean-Baptiste ([1803] 1826). Traité d'Économie Politique. Paris.


Schmitz, Stephan W. (2004). Uncertainty in the Austrian Theory of Capital. Review of Austrian Economics 17(1): 67-86.


Schumpeter, Joseph Alois ([1911] 1934). The Theory of Economic Development, Theorie der Wirtschaftlichen Entwicklung. Redvers Opie (trans.) Cambridge: Harvard University Press.


Schumpeter, Joseph Alois (1939). Business Cycles: a Theoretical, Historical, and Statistical Analysis of the Capitalist Process, 2 vols.  New York:  McGraw-Hill.


Sechrest, Larry J. (2001). Capital, Credit, and the Medium-run. Quarterly Journal of Austrian Economics 4(3): 63-77.


Silberberg, Eugene (1978). The Structure of Economics: A Mathematical Analysis. New York: McGraw-Hill.


Spadaro, Louis M. (1978). Toward a Program of Research and Development for Austrian Economics. In Spadaro, Louis M. (ed.) New Directions in Austrian Economics. Kansas City: Sheed Andrews & McMeel (pp. 205-228.)


Sumner, William Graham (1891). The Financier and the Finances of the American Revolution, 2 vols., New York: Dodd and Mead.


Thomas, Lloyd B. (1997). Money, Banking, and Financial Markets. New York: McGraw-Hill.


Tullock, Gordon (1987). Why the Austrians are Wrong about Depressions. Review of Austrian Economics 2: 73-78.


Tullock, Gordon (1989). Reply to Comment by Joseph T. Salerno. Review of Austrian Economics 3: 147-149.


Van den Hauwe, Ludwig (2001). Rethinking Time and Money at the Beginning of the 21st Century. Quarterly Journal of Austrian Economics 4(3): 79-92.


Van Horne, James C. ([1978] 1998). Financial Market Rates and Flows (5th ed.) Upper Saddle River NJ: Prentice Hall.


Varian, Hal R. ([1978] 1984). Microeconomic Analysis (2nd ed.) New York: W.W. Norton.


Wagner, Richard E. (1999). Austrian Cycle Theory: Saving the Wheat while Discarding the Chaff. Review of Austrian Economics 12(1): 65-80.


Yeager, Leland (1986). The Significance of Monetary Disequilibrium. Cato Journal 6:369-399.


Yellen, Janet L. (1984). Efficiency Wage Models of Unemployment. American Economic Review 74: 200-205.


Yu, Tony Fu-lai (1999). Toward a Praxeological Theory of the Firm. Review of Austrian Economics 12(1): 25-42.



* Financial support of the John William Pope Foundation is gratefully acknowledged.

[1] Entrepreneurial action is necessarily multifaceted and defies simple quantification.  Blaug (1998:227) cites several different historical views of entrepreneurship.  Entrepreneurial action includes arbitrage (Cantillon 1755), coordination (Say 1803; Kirzner 1973), innovation (Schumpeter 1911), uncertainty-bearing (Knight 1921), and most recently (Casson 1982, 1985) increasing the range of available judgments on resource allocation.

[2] Batra (1974), Britto (1980), Mills (1983), and Schmitz (2004) present models analyzing the impact of uncertainty on production.

[3] This is not a sunk cost, but the value of the capital remaining at any point in time, minus its salvage value.

[4] Keynes (1936) and Garrison (2001) both attempt to address the role of entrepreneurial and consumer expectations.  Garrison's approach is narrower, but also more modern, technical, and systematic.  Butos (2001:11-15) criticizes Garrison's approach.

[5] The author is much indebted to Sudha Shenoy for a highly enlightening conversation on the state of understanding of the causes of the Great Depression prior to the publication of Friedman and Schwartz's Monetary History of the United States (1963).  It simply was not clear whether monetary policy had been expansionary or contractionary during the thirties until this definitive study was published with its huge volume of previously unavailable monetary data.  Until then, armchair Keynesians were free to presume facts supported their conclusions.  Rothbard's (1963) reliance on subsequently ignored monetary aggregates and proxies was largely necessitated by the unavailability of more widely accepted data prior to the publication of the Monetary History.  Rothbard (1978) explains and justifies his choice of data, but see also Anderson (1949: 125-502) for a contemporary account of the Great Depression.  Responding to Keynesian assertions largely unsupported by data that monetary policy had been unambiguously and ineffectively expansionary, Friedman and Schwartz concluded that policy had been almost unambiguously contractionary.  Their conclusion does not square entirely with the facts, many of which Friedman and Schwartz were the first to document.  Policy was inconsistent, as Rothbard shows, providing some support for Keynesian claims, and this inconsistent expansionary-contractionary policy provided an especially difficulty environment for entrepreneurs' liquidation of malinvested capital, delaying recovery for nearly ten years.  In an important sense, both Keynesians and monetarists failed to see the forest for the trees.

[6] For applications of the Taylor series expansion in economics, see e.g., Henderson and Quandt 1956: 375-376; Chiang 1967: 256-258; Silberberg 1978: 48-51, 118-121; Varian 1978: 313.  For non-economic applications see Gellert et al 1975: 488-496 or nearly any calculus text.

[7] From an Austrian perspective, it can hardly be satisfactory to assume a market structure which in fact evolves spontaneously from the choices made by uncoordinated market participants.  Lewin and Phelan (2000) describe the implications of factor and expectational heterogeneity.  In their view, firms are necessarily heterogeneous.  This is not, however, a major shortcoming of Rotemberg's model.  Of the several formalizations of market structure, monopolistic competition is widely regarded as offering the broadest applicability and most realism.

[8] This functional form is used only for illustrative purposes.  No assumption is made about returns to factors.  The Cobb-Douglas function is additive in logarithms.  Note that though this production function incorporates multispecific capital, it follows the esablished practice of modeling labor as homogeneous.  Given the Hayekian theory of the production structure, it is especially attractive to consider an additive production function of the form Yt = å(i = 0)qi(t - i), where the qis are the value added in each stage of production.  The qis can be considered sums of the value added by each factor used in a particular stage.  Henderson and Quandt (1959:39-40) describe additive utility functions, though not production functions, discussing some of their mathematical properties. 

[9] The information set must either be capable of being characterized by some unique cardinal measure, e.g., such as Gödelization with prime numbers (Gödel 1931; Nagel and Newman 1958; Gellert et al 1975:720-723), or less restrictively, differences in the information set can be unambiguously characterized as greater, less, or indeterminate, at least hypothetically.  This determination is, in reality, always subjective.  The ordering must be homothetic but need not be additive over individuals.  Indeterminate differences, where an individual is aware the information set has changed, but cannnot decide how the existing production plan should be modified in response, result in no change to the production plan.