IS-LM Analysis Is Unable to Handle the EX ANTE Situation with Investment NOT Equal to Savings

The fundamental problem with the IS curve is that the equilibrium condition that defines the curve ignores the crucial difference between ex ante and ex post savings and investment. Ex post investment always equals savings, i.e., if investment is taking place, the savings must have come from somewhere. However, investment and savings need not be equal ex ante, and this is the point that IS-LM analysis is unable to handle. If the market rate of interest is inconsistent with the underlying preferences of savers and investors, then ex ante savings and investment may not be equal, triggering system-wide changes in prices and resource allocation, including labor. The whole Wicksellian / monetary equilibrium tradition we shall explore is centered around the way that market forces attempt to correct ex ante disequilibria, and the patterns of discoordination that such attempts can engender. For Wicksellians, it is ex ante disequilibria in the loanable funds market that explain movements in the price level and the resulting economic discoordination. However, by not addressing the possibility of ex ante disequilibrium, the IS-LM mechanism, and Keynes of The General Theory, overlook the entire set of problems that interest a post-Wicksellian, and to that extent Austrian, macroeconomist. 

—Steven Horwitz, introduction to Microfoundations and Macroeconomics: An Austrian Perspective, Foundations of the Market Economy (London: Taylor & Francis e-Library, 2003), 8-9.

Forced Saving Occurs When Investment Expenditure Is Financed by Monetary Expansion

 According to Keynes, fiscal expansion would increase the price of ‘wage goods’ (that is, consumer goods) as a result of diminishing returns. This would simultaneously reduce real wages and increase profitability. Yet the concept of ‘forced saving’ was denied. Forced saving occurs when investment expenditure is financed by monetary expansion: as resources are reallocated to the production of capital goods, fewer commodities are available to consumers, and so forced saving takes place. Forced saving provided a key element in the Loanable Funds theory of interest rate determination. Later attempts to reconcile the Loanable Funds theory with Keynes’s Liquidity Preference theory are critically examined, and the latter is judged to be an unwarranted generalisation based upon very special circumstances.

—G. R. Steele, introduction to Monetarism and the Demise of Keynesian Economics (New York: St. Martin’s Press, 1989), 4.

The Interest Rate Is a Function of the Supply and Demand for Loanable Funds

The business cycle is caused by the changes in the money supply that affect relative prices, and most importantly, the interest rate. One might consider why investors do not perceive these misleading price signals, and the reason is that individuals are not in a good position to separate out changes in prices due to changes in underlying supply and demand conditions from changes in prices due to monetary factors. In addition to the inevitable uncertainty about the future that has already been noted, as economic progress occurs, people may change their time preference. Increasing incomes can lead individuals to defer some consumption until later, saving more and consuming less in the present. This would increase the supply of loanable funds and lower the interest rate as a result of real changes in preferences rather than changes induced by monetary factors. Savers and investors can respond to market signals, but do not have a good way of separating interest rate changes caused by changes in time preference from changes due to monetary fluctuations. 

Garrison (2001) discusses changes in the interest rate that might be due to technological advances. If a new technology is developed for producing consumer goods, that technology might require investment in the short term to produce the goods that are anticipated to be profitable in the long run. An increase in investment demand will cause the interest rate to rise in the short run, but that short run might be a period of years before the technology is finally in place and able to deliver the consumer goods. This is an example with the larger point being that the interest rate is a function of the supply and demand for loanable funds. Many factors influence the supply and demand for loanable funds, and the effect of monetary expansion and contraction on the supply of loanable funds is only one factor. Entrepreneurs will, of course, try to discern and separate monetary causes for fluctuations in the interest rate from other causes, but in a complex economy nobody can do this perfectly. Market participants can see the actual market rate but can only conjecture about the importance of various factors that cause that rate to be at its current level. 

—Randall G. Holcombe, Advanced Introduction to the Austrian School of Economics, Elgar Advanced Introductions (Cheltenham, UK: Edward Elgar Publishing, 2014), 80-81. 

Non-Austrian Views of the Business Cycle View a Booming Economy as a Healthy One

Rothbard (1963), taking an Austrian school approach, describes the cause of the Great Depression as the result of malinvestment that occurred during the 1920s. Monetary expansion during the 1920s led to the boom period described by Mises and Hayek. The Keynesian explanation for the Depression is that aggregate demand declined, largely due to the volatility of investment demand that suffered a substantial reduction after the stock market crash of 1929. The monetarist explanation was that because of problems with the banking system, the money supply declined precipitously following the 1929 stock market crash, and that monetary contraction turned what would have been a much less severe recession into the Great Depression. 

The Austrian explanation distinguishes itself by tracing the causal factors back to malinvestment during the upturn in the cycle. The problems leading to the business cycle occur during the upturn, and the downturn is the recovery phase, during which dislocations occur as people reallocate their resources away from unsustainable uses, as Horwitz (2000) notes. The significance of malinvestment as a cause of the downturn naturally focuses attention on the importance of recognizing the heterogeneity of capital. The Keynesian, monetarist and more recent general equilibrium models of the business cycle do not see the causes as being created by malinvestment prior to the downturn because those models do not account for the heterogeneity of capital. Non-Austrian views of the business cycle view a booming economy as a healthy one, whereas the Austrian school sees the downturn as the inevitable consequence of malinvestment during the boom phase.

—Randall G. Holcombe, Advanced Introduction to the Austrian School of Economics, Elgar Advanced Introductions (Cheltenham, UK: Edward Elgar Publishing, 2014), 80.