Austrian Business Cycle Theory: examination of theory and evidence

Abstract

The purpose of this study is to examine the Austrian Business Cycle theory and the state of empirical evidence for it.

In the theoretical part of the study, the Austrian theory of the business cycle based on the neo-Austrian diagrammatical synthesis was compared to New Keynesian short-run IS-LM and medium-run AS-AD models by studying policy responses. The policy responses to an in-crease in saving rate and increase in government deficit spending were similar. The policy response to monetary expansion was different between the theories. In New Keynesian theo-ry, monetary expansion can be used as a stabilization instrument. In Austrian theory, it causes an unsustainable investment that is the cause of the business cycle.

The result of literature study on the previous empirical studies on Austrian business cycle theory was that there has not been a hypothesis that could be used to statistically test distinc-tively the Austrian business cycle theory. Currently there is no credible empirical evidence for the theory.

In the empirical part of the thesis, the relationship between consumption, investment and monetary policy was studied using Vector Error Correction Model (VECM). Spread between short and long term interest rates was used as a proxy for the monetary policy. The model was estimated using U.S. data from 1963 to 2014. The impulse-response functions of the VECM model indicated that a monetary policy shock causes an economic stimulus that peaks after 20 quarters for consumption and after 16 quarters for investment. The results of the empirical study are consistent with both Austrian and New Keynesian theory.