Austrian Business Cycle Theory Incorporates Aspects of a Number of Alternative Theories, e.g., Classical, Phillips Curve etc.

At first, the Austrian theory of business cycles appears very different from other main schools of macroeconomic thought. Yet a comparison shows that it actually incorporates a number of features of alternative theories. Garrison (2001; Ch. 12) provides a useful—if stylized—overview, summarized in Figure 1. 

In the Classical view, the economy operates on the production possibilities frontier (ppf), and agents have a choice between consumption and investment, which therefore tend to move in opposite directions. Over time, higher investment implies faster growth, which leads to a ppf that moves up and to the right more quickly. A choice for higher immediate consumption tends to slow growth. In the Classical view, there is no room for short-term fluctuations, only secular growth. 

In the Keynesian view, the economy is generally not on the ppf. Left to its own devices, the economy suffers from a chronic lack of demand, leaving it in a continuous state of semi-depression. Expansionary economic policies can increase demand and move the economy towards the ppf. Note that investment and consumption generally move together, in response to increases and decreases in aggregate demand. 

Real business cycle theories see all fluctuations as caused by real shocks. Markets are assumed always to be in equilibrium, and there are no departures from the ppf. Business-cycle related movements that appear to take the economy off the original ppf are considered to be the result of movements of the ppf itself, driven mostly by stocks to productivity.

Theories that incorporate a Phillips curve postulate a (temporary) tradeoff between inflation and unemployment. An unanticipated monetary expansion will allow the economy to operate beyond the ppf, but only temporarily, as long as it takes prices to adjust. The policy-induced boom is unsustainable; eventually, prices will rise and the economy will settle back on the ppf. Expectations-augmented versions of the theory require a continuously accelerating rate of inflation to sustain production beyond the ppf. 

Austrian business cycle theory incorporates aspects of a number of these alternatives: it draws heavily on classical theory by stressing the preference-based tradeoff between consumption and investment, but acknowledges the potential for the economy to operate beyond the ppf, as in Phillips-curve based theories. But in Austrian theory, the economy does not simply return to the ppf after the boom. The initial credit-induced changes in investment were not based in preferences and thus prompted a mismatch between the structure of production and planned future consumption. This triggers a change in intertemporal relative prices, raising the interest rate, which triggers a recession. Attempts by the monetary authorities to stave off recession are doomed to failure; the economy needs time and unfettered interest-rate signals to readjust its capital base to the structure of demand. 

—Stefan Erik Oppers, “The Austrian Theory of Business Cycles: Old Lessons for Modern Economic Policy?” (working paper no. 02/2, International Monetary Fund, 2002), 14-15, https://www.imf.org/external/pubs/ft/wp/2002/wp0202.pdf.