Austrian Model: Study with Video Lessons, Practice Problems & Examples

The Austrian Model of Economics, developed by Karl Menger and Friedrich von Hayek, emphasizes a free market system over government planning. It introduces the business cycle concept, where lower interest rates lead to increased investment and production, but can also result in deeper recessions. This model gained relevance during the Great Recession (2007-2009), illustrating how excessive investment in housing, fueled by low interest rates, created a market bubble. Understanding these dynamics is crucial for grasping the relationship between interest rates, investment, and economic cycles.

Austrian Model

Throughout this course, we're focused mainly on the Keynesian Model of Economics. Let's check out another model real quick, the Austrian Model. So the Austrian Model of Economics was an early model. It was an early model that was developed, that supported a free market system similar to the classical model and it supported a free market system over government planning. The government planning everything about, the economy. Okay? So this was developed by some Austrian Economists, Karl Mender and Friedrich von Hayek over the period of a few decades from 1890 to 1930. So notice this was before the Great Depression of the 1930s, right? So in the 1930s, von Hayek developed the theory of the business cycle. And remember, the business cycle, this is where we have expansions and recessions, right? Expansions and recessions in the economy. So the economy goes through an expansion, it reaches a peak and then it recedes a little bit through a recession, it hits a bottom and it expands again, right? So, he believed that when central banks lower their interest rates, firms increase their investment, right? And we've studied stuff like that, right? When the interest rates are lower, that makes it easier to take out loans to make investments happen, right? So the investment increases and it leads to increased production, okay? So lower interest rates lead to increased funded by these low-interest rates. And finally, it's going just funded by these low-interest rates. And finally, it's going to lead to a recession. After a while, it leads to a recession. And then the lower that the rates go, the deeper the recession is. That's the theory that Von Hayek developed regarding the business cycles here. Okay? So the business cycle basically, the lower the interest rate goes, the more the expansion increases and the deeper the recession is when it finally hits. However, in 1936, Keynes produced his theory of economics, which became widely adopted, the Keynesian model. What we've studied throughout this course. And it drove interest away from the Austrian model. However, the great recession, the one that happened in 2007 to 2009, it actually fit the Austrian model pretty well. So think about what we just talked about with the interest rates and how it affects investment and leads to recessions. So, in 2001, there was a smaller recession and the Fed lowered interest rates. So remember how our Austrian model started with lower interest rates that led to increased firm investment. Okay? Now, instead of building factories, a lot of this increased investment was in new housing. Okay? So a lot of the spending was in new housing with these low-interest rates. New houses were built and the housing market, the real estate market surged, okay? The excessive investment in housing ended with a bubble and then, we ended up in the Great Recession. So we have very low-interest rates that led to huge investments in the housing market. Eventually, the housing market crashed and we went into a deep recession because of the low-interest rates that the Fed had established. Okay? So that's the idea of the Austrian model is basically focused on this business cycle and how low-interest rates affect the business cycle, and lead to recessions. Okay? So that's about it with the Austrian Model. Let's go ahead and pause and move on to the next video.

Here’s what students ask on this topic:

What is the Austrian Model of Economics?

The Austrian Model of Economics, developed by Karl Menger and Friedrich von Hayek, emphasizes a free market system over government planning. It introduces the concept of the business cycle, where lower interest rates lead to increased investment and production. However, these low interest rates can also result in deeper recessions. The model gained relevance during the Great Recession (2007-2009), illustrating how excessive investment in housing, fueled by low interest rates, created a market bubble. Understanding these dynamics is crucial for grasping the relationship between interest rates, investment, and economic cycles.

Who were the key figures behind the Austrian Model of Economics?

The key figures behind the Austrian Model of Economics are Karl Menger and Friedrich von Hayek. Karl Menger is considered one of the founders of the Austrian School of Economics, while Friedrich von Hayek further developed the model, particularly with his theory of the business cycle. Their work emphasized the importance of a free market system over government planning and highlighted how interest rates influence economic cycles.

How does the Austrian Model explain the business cycle?

The Austrian Model explains the business cycle through the relationship between interest rates and investment. According to Friedrich von Hayek, when central banks lower interest rates, firms increase their investment due to cheaper borrowing costs. This leads to increased production and economic expansion. However, these low interest rates can also create excessive investment, leading to economic bubbles. When these bubbles burst, the economy enters a recession. The model suggests that the lower the interest rates, the deeper the subsequent recession.

How did the Austrian Model gain relevance during the Great Recession?

The Austrian Model gained relevance during the Great Recession (2007-2009) because its principles closely matched the economic events of that period. The Federal Reserve had lowered interest rates significantly, leading to a surge in investment, particularly in the housing market. This excessive investment created a housing bubble. When the bubble burst, it resulted in a deep recession, aligning with the Austrian Model's prediction that low interest rates can lead to severe economic downturns.

What is the role of interest rates in the Austrian Model of Economics?

In the Austrian Model of Economics, interest rates play a crucial role in influencing the business cycle. Lower interest rates make borrowing cheaper, encouraging firms to increase their investment and production. However, these low rates can also lead to excessive investment and economic bubbles. When these bubbles burst, the economy enters a recession. The model suggests that the lower the interest rates, the more severe the subsequent recession, highlighting the delicate balance central banks must maintain.