1. Jared Friedman
1
Figure 2
Business Cycle Peaks and Troughs in the United States, 1890-2004
(National Bureau of Economic Research)
(Romer, 2008).
Figure 1
Phases of the Business Cycle
(Investopedia, 2012)
Austrian Business Cycle Theory
What is the Business Cycle and Why is it So Harmful to Economic Progress?
What is the Business Cycle? 1
All developed economies undergo dramatic shifts in economic activity. During some
periods, the economy is booming and unemployment is relatively low. These periods of
economic wealth and prosperity are often referred to as expansions or booms. During other
periods, the economy is in decline, operating significantly below capacity and with high
unemployment. These periods of economic decline are often referred to as recessions or
depressions. When combined, the expansions and recessions characterize the ebb and flow of
economic activity and are called business cycles.
1
Much of the information provided in this section is drawn from the excerpts contained in The Concise
Encyclopedia of Economics: Business Cycles by Christina D. Romer.
Romer, C. D. (2008). The Concise Encyclopedia of Economics: Business Cycles. Retrieved December 2012, from
Library of Economics and Liberty: http://www.econlib.org/library/Enc/BusinessCycles.html

2. Jared Friedman
2
Business cycles are identified according to when the direction of economic activity
changes. The peak of the cycle refers to the last month before several economic indicators (i.e.
employment, output, and retail sales) start to fall. The trough of the cycle refers to the last month
before the same economic indicators begin to rise. Figure 1 illustrates the business cycle
graphically and Figure 2 details the business cycle peaks and troughs in the United States from
1890-2004.
Why is the Business Cycle So Harmful to Economic Progress?
So why is the business cycle so harmful to economic activity and economic prosperity?
The problem stems from the fact that while the business cycle may seem formulaic and
predictable, it is far from it. Contrary to popular belief, it is not possible to accurately predict
when a downturn will occur, or more importantly, how quickly things can go from peak to
trough. The business cycle leads to significant market crashes and high levels of unemployment
that render economic predictability exceedingly difficult. As such, it is increasingly difficult for
entrepreneurs and business people to make accurate long-term investments. Ultimately, this type
of uncertainty yields an unstable economic environment. Looking at Figure 3, it becomes clear
how quickly unemployment can rise and how unpredictable recessions/depressions can both
occur and last.

3. Jared Friedman
3
So what causes the business cycle? Is it simply a product of the free market or is it a
process created by government intervention in the free market? And, is it avoidable? To answer
these questions, first it is necessary to understand the fundamentals of Austrian Economics and
the price mechanism.
What is the Austrian School of Economics?
The Austrian School of Economics is a school of economic thought that gets its name
from its Austrian founders and early supporters who espouse the belief that a free market price
mechanism does the best job of organizing the spontaneity of economic activity (Ludwig Von
Mises Institute, 2012). More importantly, and perhaps more controversially, the Austrian School
believes that the inherent complexity and subjectivity of human decision making makes
Figure 3
Unemployment Rate and Recessions
Source: The data are from the Bureau of Labor Statistics.
Note: The series graphed is the seasonally adjusted civilian unemployment rate for those ages sixteen and over. The shaded
areas indicate recessions.
(Romer, 2008)

4. Jared Friedman
4
mathematical modeling of the market virtually impossible and therefore it considers much of
mainstream economics, which depends heavily on mathematical modeling of the economy, to be
entirely useless. (Ludwig Von Mises Institute, 2012)
Proponents of the Austrian School of Economics advocate for the strong protection of
private property rights and the strict enforcement of voluntary contractual agreements between
individuals; otherwise, Austrian economists advocate a laissez-faire approach to the economy
and maintain that it is the most effective way to produce long-term economic stability and well-
being (Ludwig Von Mises Institute, 2012).
So, how does a free market economy produce long-term economic stability and how does
this relate to Austrian Business Cycle Theory? The next section dives deeper into the price
system, laying the foundation for understanding in greater depth the Austrian Business Cycle
Theory and its implications.
The Economic Calculation Problem and the Price System
Economic Calculation Problem
In 1920, Ludwig von Mises (later developed by Friedrich Hayek) proposed the economic
calculation problem whereby he sought to solve the problem of how to rationally distribute
resources most efficiently in an economy (Ludwig Von Mises Institute, 2012). According to the
principles of a free market system, the ideal solution is to produce and distribute goods and
services according to the price mechanism or price system, a system that Mises and Hayek would
ultimately argue is the only system capable of solving such a problem. (Ludwig Von Mises
Institute, 2012)

5. Jared Friedman
5
Price System2
So what is the price system and how does it function? Essentially, the price system is a
means of organizing economic activity. The price system organizes economic activity primarily
by coordinating the decisions of consumers, producers, and owners of the means of production
(i.e. productive resources). Millions of economic agents who have no means of direct
communication with one another are guided by the price system to supply each other’s wants. A
consumer can purchase a product that he has never bought before, produced by a company he is
unaware exists. So how is this possible? The answer, to put it simply, is prices. Prices express the
unanimous value of different things, and every society that allows the exchange of goods and
services between people has prices. Because prices are expressed in terms of a widely acceptable
commodity, they allow people to make an easy comparison of the comparative values of various
other commodities or products. For example, if pants are $20 per pair and peanut butter is $1 per
jar, then a pair of pants is worth 20 jars of peanut butter. Essentially, the price of any good or
service is its value in exchange for a commodity of wide acceptability.
A system of prices exists because individual prices are related to one another. If, for
example, the cost of a flat 2’x3’ piece of cardboard costs $0.85 and the cost of folding that flat
piece of cardboard into a pizza box costs $0.25, then it will be profitable to produce pizza boxes
from flat pieces of cardboard only if its price exceeds $1.10. To express this formulaically:
𝑃𝑟𝑜𝑓𝑖𝑡 = 𝑅𝑒𝑣𝑒𝑛𝑢𝑒 (𝑈𝑛𝑖𝑡 𝑃𝑟𝑖𝑐𝑒 𝑥 𝑄𝑢𝑎𝑛𝑡𝑖𝑡𝑦 ) − 𝐶𝑜𝑠𝑡 (𝑈𝑛𝑖𝑡 𝐶𝑜𝑠𝑡 𝑥 𝑄𝑢𝑎𝑛𝑡𝑖𝑡𝑦)
2
Much of the information provided in this section is drawn from the excerpts contained in Encyclopaedia
Britannica. (2012). Encyclopaedia Britannica Online Academic Edition. Retrieved December 2012, from
Encyclopaedia Britannica Inc.: http://www.britannica.com/EBchecked/topic/475822/price-
system?anchor=ref212552

6. Jared Friedman
6
Ultimately, everyone must make basic choices about what and how much they are going
to consume. For example, some people may choose to spend more on shelter than on food, while
others may choose to spend more on food than shelter. Ultimately, a price system weighs the
desires of each consumer in terms of the price they are willing to pay for differing quantities of
each good or service they want. While it is true that the amount that consumers agree to pay for
certain goods and services is in part influenced by their wealth and their desires, for any one
consumer, relative desire is strictly proportional to the price of each good or service he or she is
considering purchasing.
To understand how much of a good or service will be provided or consumed at a given
price, it is important to understand the fundamentals of the economic laws of supply and
demand. Figure 4 illustrates the relationship of price to supply and demand.
Figure 4
Illustration of the relationship of price to supply (S) and demand
(D). (Encyclopaedia Britannica, 2012)

7. Jared Friedman
7
Examining the graph, it is easy to see that at any given price, p, a given quantity, q, will
be both supplied (i.e. produced), exhibited by line S, and demanded (i.e. consumed), exhibited by
line D. At the point where the green arrows meet, supply equals demand and the market clears.
In other words, the amount supplied is exactly equal to the amount demanded. There are no
goods or services left over at that given price. For example, if the quantity of shoes demanded at
a price of $20 is 1000 and the quantity supplied at a price of $20 is 1000, then all shoes that are
produced at $20 will be purchased. There will be no extra shoes left over.
So why is this important? By allowing the free market to adjust and set the market
clearing price, resources are employed as efficiently as possible. Resources are not wasted
because they will be used to push supply and demand towards the market clearing price. If the
price is set too low, then suppliers will not produce many shoes. But, since demand is so high at
the low price it will push prices up, signaling to producers to produce more shoes. When prices
become too high, demand will fall relative to supply and ultimately prices will fall to meet
demand and clear the market. This constant ebb and flow is necessary. When prices are
constantly moving in a free market, they are signaling to buyers and sellers the relative value of
goods and services. More importantly, they are signaling to buyers and sellers where resources
should be directed.
If demand for shoes is so high that the price jumps from $20 to $40, this signals to the
suppliers that shoes are a highly valued product and that they should invest more resources (i.e.
purchase more leather, shoe laces, machinery, etc.) in producing more. This mechanism is
perhaps the single greatest feature of a laissez-faire market pricing system.
However, what were to happen if, for example, the government were to step in and set a
price ceiling (the maximum price for which a product can be sold)? In this case, if the price of

8. Jared Friedman
8
shoes in a free market were to jump from $20 to $40 but the government stepped in and said that
since shoes are a necessity shoe companies cannot charge more than $30, that $40 was too high a
price to pay for shoes, then the quantity of shoes demanded would greatly exceed the quantity
supplied. In other words, there would be a shortage of shoes! At $30, more people would want to
buy shoes than producers would want to manufacture shoes. Ultimately, this leads to a wasteful
distribution of goods.
So, what does all of this have to do with the business cycle and the Austrian point of
view? It’s now time for the big reveal.
What is Austrian Business Cycle Theory?
So what is Austrian Business Cycle Theory? Austrian Business Cycle Theory posits that
banks expand credit beyond their own asset base by using funds from depositors; this is often
supported and encouraged by low interest rates set by a central bank (Ludwig Von Mises
Institute, 2012). So what does this mean? This means that when a central bank wants to stimulate
growth in a sluggish economy, it artificially lowers the interest rate (the cost of borrowing). By
doing so, the central bank makes it appear as if there are more loanable funds (funds that have
been saved by depositors in a bank) to be lent out to investors and entrepreneurs. Recall from our
discussion of the price system that if prices (i.e. the costs of borrowing) are low, then demand
(i.e. the amount of funds that investors and entrepreneurs will want to borrow) will be high.
Ultimately, there will be a shortage—more funds will want to be borrowed than there are funds
available (i.e. saved) in banks.
So how is this shortage resolved? In the case of the shoe shortage there is no way to
magically make more shoes appear. However, we can distort the market through government
intervention and use resources that would have otherwise been used to manufacture another

9. Jared Friedman
9
good, for example belts, to meet the shortage of shoes. Needless to say, this means that fewer
belts can be currently manufactured. The shifting of resources in this case is simultaneous. More
shoes now equal fewer belts now.
But how do we resolve a shortage of loanable fund? Can we magically create more
money to bridge the gap between supply and demand? The answer, unfortunately, is yes.
Government can simply issue more fiat currency (i.e. print more money). However, unlike a
simultaneous shift in resources as demonstrated by the shoe and belt example, increasing the
money supply and lowering interest rates shifts resources from the future to the present.
Central banks expand the money supply and increase current consumption by effectively
lowering our consumption in the future. The more we consume now, the more we will have to
forego in the future. This is where Austrian economists make their mark. When central banks
lower interest rates and inflate the money supply, much of the funds are malinvested. We invest
in projects that we otherwise would not have invested. Since the market never indicated
sufficient demand, as there was never enough money in savings to indicate otherwise, what we
see is an artificial boom—a period of wasteful spending that ultimately comes to fruition when a
significant number of these investments become insolvent and unsustainable. When they do, the
boom turns to bust. Since there was never enough savings to sustain these investments, these
investments inevitably fail and often times take the market with them.
Ultimately, by sticking to the fundamentals of free market economics and the intricacies
of its workings, the Austrian School and its followers have become notorious for exposing
financial bubbles before they burst. More importantly, the Austrians, through much of their
work, have found an answer to the disastrous effects of the business cycle—in short, they can be

10. Jared Friedman
10
mitigated by the absence of government intervention in the market and if we adopt a
philosophically laissez-faire approach to economics.
Works Cited
Encyclopaedia Britannica. (2012). Encyclopaedia Britannica Online Academic Edition.
Retrieved December 2012, from Encyclopaedia Britannica Inc.:
http://www.britannica.com/EBchecked/topic/475822/price-system?anchor=ref212552
Encyclopaedia Britannica. (2012). Encyclopaedia Britannica: Supply and Demand. Retrieved
December 2012, from Encyclopaedia Britannica Online Academic Edition:
http://www.britannica.com/EBchecked/topic/574643/supply-and-demand
Investopedia. (2012). Definition of 'Trough'. Retrieved December 2012, from Investopedia.com:
http://www.investopedia.com/terms/t/trough.asp#axzz2F4AfETuR
Ludwig Von Mises Institute. (2012). Austrian Business Cycle Theory. Retrieved December 2012,
from Mises Wiki: http://wiki.mises.org/wiki/Austrian_Business_Cycle_Theory
Ludwig Von Mises Institute. (2012). Austrian School. Retrieved December 2012, from Mises
Wiki: http://wiki.mises.org/wiki/Austrian_School
Ludwig Von Mises Institute. (2012). Economic Calculation Problem. Retrieved December 2012,
from Mises Wiki: http://wiki.mises.org/wiki/Economic_calculation_problem
Romer, C. D. (2008). The Concise Encyclopedia of Economics: Business Cycles. Retrieved
December 2012, from Library of Economics and Liberty:
http://www.econlib.org/library/Enc/BusinessCycles.html