The Type of Economy Determines the “Propagation Mechanism,” How the Economy Reacts to Monetary or Real “Impulses”

The crucial property of a money economy is that, absent neutral money, a divergence of investment from voluntary saving becomes possible. In particular, Hayek considers an excess of investment over saving, financed by credit creation (inflation), as the root cause of maladjustments in the structure of production and thus ultimately of the crisis. These maladjustments will arise irrespective of whether the exogenous change that generates excessive investment originates from the monetary or the real side. Or put in terms of the interest rate criterion: It does not matter if a discrepancy comes about by a fall in the money rate or a rise in the natural rate—the former resulting from a policy of monetary expansion, the latter from an increase in the (expected) rate of profit, possibly due to technical progress. Indeed, Hayek in Monetary Theory and the Trade Cycle stressed fluctuations in the natural rate (relative to an unchanged money rate) as the typical impulse, while later on in Prices and Production he started the analysis of maladjustments from assuming a fall in the money rate. Framing the problem—anachronistically—in terms of Ragnar Frisch’s famous distinction, the type of economy—money or barter—determines the propagation mechanism, that is, how the economy reacts to impulses, be they monetary or real. According to Hayek it is the distinguishing property of a (non-neutral) money economy that it will not react to such impulses by an immediate tendency towards equilibrium.

—Hansjoerg Klausinger, ed., editor’s introduction to The Collected Works of F. A. Hayek, vol. 7, Business Cycles, Part I, by F. A. Hayek (Carmel, IN: Liberty Fund, 2017), 19-20.