I was looking up on this website Howstuffworks.com to learn about what exactly the Fed does to manipulate currency. So, I know this is a simple question, but where is the error in the image above?
You can’t have lower interest rates if both consumption and the demand for loanable funds has increased.
Also more jobs does not equal low interest rates. In free market more savings equals low interest rates. Currently interest rates are forcefully set by FED.
Lol, correct me if I’m wrong, but isn’t this basically a diagram for how inflationary bubbles occur?
Yes it is, but I just wanted to ask how exactly that is, or what is wrong with the image.
So I guess the part that really confused me is the more jobs leading to lower interest rates. Everything else seems straightforward. Why would more jobs lead to lower interest rates. How would it have any effect on interest rates at all?
I mean as far as I can tell, this circle should lead to higher interest rates because capital is becoming more scarce. Why would this say lower interest rates?
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Lower interest rates are not the product of “more jobs” per sé. Interest rates are lowered when the supply of saved/accumulated capital increases, relative to the volume of demand for capital. More jobs, assuming wages remain the same, can lead to lower interest rates if saved income increases.
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While consumer credit does mean that borrowed money is used for present consumption, the majority of borrowed capital is invested. The illustration doesn’t distinguish between the two, which is common in Keynesian theory as well. There is a difference between consuming and investing a good.
Note that I’m not disagreeing with you, I’m just trying to understand the theory with these questions.
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So this cycle seems to have a problem. If you artificially lower the interest rate, then the money that you loaned represents nothing. The people who make the money making the things that people buy with the borrowed money have no money really. I know, inflation will average things out, and all money is worth the same, but where does the problem come about. Sure, inflation has occurred, but you can’t get something for nothing. Where does the problem of loaning money attached to no value rear its ugly head?
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What is the importance of this?
The problem is that money is not neutral, and inflation does not “average out”. Inflation distorts prices relative to each other, which is why lower interest rates tend to push entrepreneurs to invest in capital-goods, which is what causes the business cycle.
Consumption does not create wealth, investment does.
It’s the Keynesian circular flow for dummies. I believe it’s taken from this book:
BTW, there is anothe rpice of the puzzle that cute lil chart leaves out. Low interest rates created by inflation will lead to high interest rates. Because nobody will lend money unless they get back what they guess inflation is going to eat up of the money loaned.
Oh yeah, one last thing. If low interest rates are so wonderful, why has the Fed EVER set interest rates at higher than zero? Why not keep them low since day one and forever? What’s wrong with this picture?
Low interest rates, means less savings, which means less wealth to lend out, which means less demand, which leads to fewer jobs. They have it bass ackwards. If one looks at reality, is there really any lending or borrowing going on with 0% interest rates besides with the government sector? Nope.
negative interest rates forever! prosperity from the printing press !!! wooooooh!
From what I understand this picture is correct, and indeed this is precisly what happens in reality. (In a sense)
However there is a huge problem. The problem rests in the fact that this picture assumes citizens are BORROWING money to spend, creating the jobs (which then places credit for this miraculous process on artificially low interest rates). This is a fallacious argument since this process is unsustainable. Eventually the people must pay their debts back, and at that point, they cease spending (or creating jobs).
The healthy way this process works is through individuals creating demand from their own savings instead of accumulated debt.
This picture is assuming that in order to have a functioning economy, we must create unsustainable bubbles.
Also, on the free market, a low interest rate does not come into being through people spending, but rather through saving. All based on individual time preferences respectfully.
The interest rate shown here should be high, not assuming FED intervention.
The errors are revealed by reference to ABCT:
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It ignores capital formation and the time structure of production. Time preference and real savings determine the interest rate. The capital structure of production should have been laid out first, then the central bank intervention should be overlaid to show the resulting distortions (malinvestment). (I am working on such diagrams myself.)
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It ignores the central bank first buying government debt, expanding demand deposits, fractional reserve banking, and the money multiplier effect during the credit exapansion.
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The loans seem to go the consumers (the hand), but actually go to “the factory” first (more round about production). The factory should be in the first frame, not the last. With the factory in the last frame, where does the factory get the money to expand? Internal profits alone?
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Assuming we don’t have a “broke banking system” like we do now (liquidity trap in Keynesian claptrap terms), industry starts consuming resources, putting upward pressure on the price of factors of production. The distortion of the structure of production is ignored in the diagram. The structure has become artificially more round about, even though real savings are insufficient to support it.
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The longer term projects are not sustainable because there were never sufficient resources to support such a structure to begin with. This is ignored in the diagram. ABCT reveals the errors of Keynesian flow. The bust begins.
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The misplaced factory (industry) in the last diagram cannot lead to lower interest rates. The creator of the diagram must think that industry will create savings through profits, thus somehow supporting or justifying the low interest rate, ignoring the need for the “factory” to obtain credit.
The diagram can be simplified and fixed like this: Credit expansion led by and supported by the central bank ----> Austrian Business Cycle.
I think this makes the most sense of the posts that I’ve seen. This circle does indeed ignore capital goods.
But I guess the question becomes: if people are spending more, then people are working more to meet that demand. More goods are produced. Let’s say that we just hand everyone $1000. It’s not a loan, it doesn’t have to be paid back. If people spend that money quickly enough, then prices wouldn’t rise. But I guess that this would create a problem of scarcity, and indeed prices would have to rise before people could get all of the things that they wanted. Once that happens, you haven’t really changed anything. It was a temporary bump. But what if we gave everyone $1000 every month in new money. Presumably, people would spend that money and we would get more production in order to meet growing demand. But this is ignoring the effect that this would have on human behavior and on expectation of this. If you take that into account, then what?
So yes, I can see what is wrong with the image. Too many loans, only so many capital goods, prices will rise on capital goods, and so we’ll have defaulting and a recession. But what if we just gave people the money to spend?
Lets not confuse the thing with the representative of the thing.
For example, if in a particular culture a popular girl gets a box of chocolates from a guy who likes her, then a very popular girl will get a lot of boxes.
Now if some plain homely girl is feeling bad that she is unpopular, she can do one of two things. She can either work on her looks and personality and thus become popular, or she can go the store and buy many boxes of chocolates. But the latter doesn’t really make her more popular, does it?
Similarly, a country is well off financially not when everyone has more “boxes of chocolate” [=paper money], but when there is an abundance of USABLE THINGS in the country. Food, Televisions, Good Doctors, the list is endless.
How does giving everyone more green paper every month increase the amount of usable things? It doesn’t.
Hey if it worked, Zimababwe would be the rchest nation on Earth now.
Real goods would be consumed, yes, but why does it follow that there would be increased production?
Using an island economy example, if Crusoe, Friday and everyone else on the island were given “fiat coconut shell tickets” by the people in power, and the “sellers of real goods” were compelled to accept these in exchange for real goods on penalty of torture and death, you can see that real goods would indeed be consumed. But what of the production? In order to increase production, the “producer” would have to lengthen the period of production (become more round about in order to increase productivity). Where would the funds come from to lengthen this production structure? It would have to be in form of real goods, not fiat coconut shells. But real goods are being consumed in your example of giving everyone $1,000 per month. So, regardless of expectations, all I see happening by giving people $1,000 per month is that goods disappear and prices rise.
The wealth producers would go into the market to obtain the real goods they need to lengthen the production structure, but the goods are gone! How can an economy both consume and lengthen the production structure at the same time? It can’t, not sustainably. If the above economic plan was implemented, things would get ugly politically very fast.
See above, and Zimbabwe. [EDIT: Smiling Dave, saw your post after I wrote mine, we are thinking along the sames lines.]
The people who got the money first would benefit.
I know, I understand that inflation and low interest rates aren’t sustainable, I’m just trying to figure out why that is though.
Maybe this will help me. With everyone getting $1000, then everyone is buying more goods. Since companies can’t right away keep up with the demand, they will have to raise prices. In order to increase production though, they would have to get a loan. But because of the general inflation, the price of new capital goods would get more expensive.
So at this point, when companies try to increase production to meet the growing demand, what happens. Why will many companies eventually fail after taking out these loans?