The Capital-based Macroeconomic Framework

The Capital-based Macroeconomic Framework
The three components discussed above are assembled in Figure 9.7 to depict
an intertemporal equilibrium in a fully employed macroeconomy. Full employment
is indicated by the locus of this economy on its production
possibilities frontier. The particular location on the frontier is determined by
Figure 9.7 A capital-based macroeconomic frame
the loanable funds market, in which the rate of interest reflects the saving
preferences of market participants. The corresponding consumption preferences
are accommodated by the output of the final stage of production in the
Hayekian triangle. Resources are being allocated among the stages of production
on the basis of the cost of investment funds, such that the rate of
return in the real sector, as reflected in the slope of the triangle’s hypotenuse,
corresponds to the rate of return in the financial sector, as depicted by the
market-clearing interest rate in the loanable funds market. Figure 9.7 and
subsequent figures are adapted from Garrison (2001).
For an economy in a macroeconomic equilibrium as just described, the
rates of return (in both the real and the financial sectors) can be summarily
described as ‘the natural rate of interest’. Parametric changes, such as a
change in saving preferences, can change the natural rate. For instance,
increased saving preferences will cause the market-clearing rate of interest
to be lower and the slope of the triangle’s hypotenuse to be a shallower one.
The capital-based macroeconomic framework is designed to show (i) how
market forces establish a new natural rate in response to some parametric
change and (ii) how the economy reacts to policies aimed at maintaining an
interest rate in the financial sector that is inconsistent with – typically
below – the natural rate. Uses of these analytics to deal with other macroeconomic
issues, such as deficit finance and tax reform, are demonstrated
in Garrison (2001); some extensions of Austrian business cycle theory are
suggested by Cochran (2001).
In its simplest interpretation, Figure 9.7 depicts a steady-state, no-growth
economy. There is no net investment. The positive level of saving and investment
shown in the loanable funds market is just enough to offset capital
depreciation. As capital goods wear out and are replaced, the Hayekian
triangle is maintained from period to period in terms of both size and shape.
This is the circumstance that corresponds to the first two periods of Figure
9.2. If, as is ordinarily the case, investment exceeds capital depreciation, the
economy experiences secular growth in all its dimensions. The production
possibilities frontier shifts outward, both the supply and demand for loanable
funds shift rightward, and the Hayekian triangle changes in size but not – or,
at least, not necessarily – in shape. This is the circumstance that corresponds
to the last several periods of Figure 9.2. It should be noted that secular growth
in which there is no change in the shape of the Hayekian triangle presupposes
that the supply of loanable funds and the demand for loanable funds shift
rightward to the very same extent, such that there is no change in the rate of
interest. Ordinarily, we would think of the increased income and wealth that
economic growth makes possible as being accompanied by an expanding
time horizon and hence by an increased inclination to save. Factoring in
increased saving preferences would allow for a reduction in the rate of
interest and a change in the shape as well as of the size of the Hayekian
triangle.