New evidence on the structure of production: Real and Austrian business cycle theory and the financial instability hypothesis

This article develops the relationships among real business cycle (RBC) theory, Austrian business cycle (ABC) theory, and Minsky's financial instability hypothesis (FIH). In RBC models, recessions are caused on the supply side by random technology shocks which are independent of monetary policy. However, in ABC models, credit expansion results in negative productivity shocks, as the marginal return on investment is lowered and the production structure is extended by commitment to more capital-intensive activities. Thus, ABC theory helps resolve several problems with RBC theory. The FIH describes a process of endogenous overleveraging which unsustainably overvalues assets and exposes the financial sector to greater risk. This paper argues that the overleveraging described by the FIH is compatible with the unsustainable expansion of production described in ABC theory, and further argues that credit expansion would both provide additional funds to finance overleveraging, as well as encourage the process by making it cheaper with lower interest rates.

► Relationships are defined among Austrian business cycle theory, real business cycle theory, and the financial instability hypothesis.
► Inflation results in negative shocks to productivity, required by RBC to drive the business cycle, as the marginal return on investment is lowered.
► Thus, RBC models are a special case of the more general ABC model.
► The FIH describes endogenous overleveraging which overvalues real and financial assets, exposing financial intermediaries to greater risk.
► The FIH's progressive overleveraging is shown to be conceptually compatible with the unsustainable expansion of production described in ABC.