Lawrence H. White
Professor of Economics,
George Mason University Senior Fellow,
F. A. Hayek Program for Advanced Study in Philosophy, Politics and Economics, Mercatus Center at George Mason University


F. A. Hayek’s macroeconomic theory and policy ideas have gained renewed attention since the recent boom-and-bust cycle followed the basic Hayekian narrative of an unsustainable cheapmoney boom ending with a crash.

Only to a very limited extent, however, do we find Hayek’s ideas on the agenda of mainstream macroeconomic researchers since Robert Lucas’s research program gave way to “Neoclassical” and “New Keynesian” dynamic stochastic general equilibrium (DSGE) models.

We find examples of deeper interest on the periphery of the mainstream.

Hayek’s influence on today’s macroeconomic policy discussions remains similarly limited, although he has become an icon to some opponents of loose monetary policy.


Friedrich A. Hayek is best known to economists as the author of “The Use of Knowledge in Society” (1946).

He is best known to the intellectuals more widely as the author of The Road to Serfdom and Law, Legislation, and Liberty.(2)

But when the Sveriges Riksbank Committee awarded the 1974 "Prize in Economic Sciences in Memory of Alfred Nobel" jointly to Hayek and Gunnar Myrdal, the official citation mentioned first “their pioneering work in the theory of money and economic fluctuations,”
followed by
“their penetrating analysis of the interdependence of economic, social and institutional phenomena."

Hayek from the late 1920s through 1941, building on a foundation of general equilibrium thinking (“interdependence”) with blocks provided largely by Ludwig von Mises (3), developed an “Austrian” theory of the business cycle (“fluctuations”) in his works Monetary Theory and the Trade Cycle (1929),
the series of lectures published as Prices and Production (1931),
the articles collected as Profits, Interest, and Investment (1939),
and The Pure Theory of Capital (1941).

The Keynesian Revolution quickly banished the Austrian theory of the business cycle from the academic mainstream.

In exile, its most important developer since 1941 has been Roger Garrison (1978, 2001).

In recent years the theory has gained renewed attention both outside the economics profession and within.(4)

The revival of interest in Hayek’s macroeconomic theory has been prompted by real-world events and policy debates.

Many noticed that the housing boom of 2002-07, giving way to the bust of 2007-09, followed the basic Mises-Hayek- Garrison narrative: an unsustainable cheap-money boom ends with a crash.(5)

In what follows the first task will be to consider the extent to which the core ideas of Hayek’s theory have returned to the agenda of today’s mainstream macroeconomic research, particularly to analysis in terms of DSGE (dynamic stochastic general equilibrium) models, considered today’s state-of-the-art and consensus approach.

Some research on the periphery of the DSGE core will also receive attention.

Focusing on the presence or absence of Hayekian ideas in mainstream macroeconomic research will mean almost entirely neglecting recent research by self-identified Austrians and work that appears in Austrian economics journals.

The second task will be to consider Hayek’s influence on today’s macroeconomic policy discussions.
Here Hayek’s most relevant works are
the last lecture of Prices and Production,
the series of lectures published as Monetary Nationalism and International Stability (1937), and
the late-career monograph The Denationalisation of Money (1978).

1. Hayek and New Classical Macroeconomics

Hayek (1928) in his article on “Intertemporal Price Equilibrium and Movements in the Value of Money” was a pioneer of intertemporal general equilibrium theory in a production economy (Milgate 1979; Ingrao 1989, pp. 374-77; Donzelli 1993).

While Irving Fisher (1907) had offered an intertemporal equilibrium theory of the determination of the rate of interest, his use of a single composite output (at multiple dates) trading in a single (intertemporal) market, disqualified the model from being that of a general equilibrium of multiple goods and markets.

Eugen von Böhm-Bawerk’s theory of interest, and its restatement by Knut Wicksell, were only somewhat more general (labor input, capital seen as goods in process, composite output good).

Hayek (1928) was explicitly concerned with relative prices among multiple goods at multiple dates.

As David Laidler (1999, pp. 36-37) has stressed, Hayek’s 1928 article was “at least as much Walrasian in its approach as Austrian.”

In Monetary Theory and the Trade Cycle, Hayek (1929, p. 33), Hayek declared that Walrasian general equilibrium theory “most perfectly expressed” the neoclassical understanding of the general interdependence of markets.

(This statement came before the socialist calculation debate alerted Hayek to the dangers of economists regarding the Walrasian model as a blueprint for government planning.)

The core method of economics is the neoclassical “theory of equilibrium” (microeconomics or relative price theory), Hayek (1929, pp. 28-9) argued, so business cycle theory should rest on the same price-theoretic foundations:

"We cannot superimpose upon the system of fundamental propositions comprised in the theory of equilibrium, a Trade Cycle theory resting on unrelated logical foundations.

All the phenomena observed in cyclical fluctuations, particularly price formation and its influence on the direction and volume of production, have already been explained by the theory of equilibrium;
they can only be integrated as an explanation of the totality of economic events by means of fundamentally similar constructs."(6)

Hayek concluded the passage with the statement that “the crucial problem of Trade Cycle theory” is

"the incorporation of cyclical phenomena into the system of economic equilibrium theory, with which they are in apparent contradiction."

A spotlight fell on this last statement when Robert E. Lucas, Jr. (1981, p.216), the leading developer of New Classical macroeconomics (Nobel laureate 1995), quoted it and commented that

"it is likely that many modern economists would have no difficulty accepting Hayek's statement of the problem as roughly equivalent to their own."

Lucas (ibid.) went on to urge that

“the most rapid progress toward a coherent and useful aggregate economic theory will result from … a resumption of the work of pre-Keynesian theorists.”

The general-equilibrium turn in macroeconomics began in earnest with Lucas’ 1972 paper on “Expectations and the Neutrality of Money” (in Lucas 1981, pp. 66-89).

This was the first fleshed-out example of what Lucas (1981, p. 271) would later call “fully articulated, artificial economic systems” in which rigorous GE policy simulations can be conducted.

From Lucas’ work came New Classical macroeconomics, and from that came today’s DSGE models.

Like Hayek, Lucas in the 1970s and ‘80s emphasized money-supply shocks as the initiator of cyclical movements.
Granted, Lucas rejected Hayek’s transmission mechanism of an artificially low real interest rate causing malinvestment.(7)

He put in its place a Walrasian version (the “archipelago” construct of informationally separated agents) of the monetarist mechanism of real-wage misperception.

Like Hayek, Lucas criticized the Keynesian economics of his day for lacking equilibrating market forces and thereby being inconsistent with neoclassical microeconomics.
Granted, Lucas had a different idea from Hayed about what compatibility with microeconomic theory meant, and used different techniques.

(In Lucas’s models, the price vector for each period must be consistent with a general equilibrium that clears all markets, and there can be no talk about markets in “disequilibrium.”).

Many historians of economic thought have emphasized these differences.(8)

Lucas (1994, p. 274) himself later told interviewers:

“I once thought of myself as a kind of Austrian, but Kevin Hoover’s book persuaded me that this was just a result of my misreading of Hayek and others.”

This humble disclaimer is too sweeping.

In matters of substance, Hayek can be regarded as an intellectual grandfather of Lucas’s approach.

But a change in the intellectual environment blocked the transmission of Lucasian and hence those Hayekian memes to contemporary mainstream macroeconomics.

The Lucasian strand of the New Classical School was shunted to the sidelines by the “real business cycle” strand, pioneered by Finn Kydland and Edward C. Prescott (who shared the 2004 Nobel).

Kydland and Prescott and their followers emphasize real supply or technology shocks.

In a nutshell, their time-series evidence (using novel techniques of calibration and simulation) convinced Lucas to abandon the view that monetary forces drive the typical cycle.

As Lucas (in Breit and Hirsch 2009, p. 295) has recounted it, “the end of my attempts to account for the business cycle in terms of monetary shocks” came when Kydland and Prescott developed a neoclassical growth model that allowed for Lucas-type monetary shocks but also for stochastic technology shocks, and took it to the data.

They found, in Lucas’ account (ibid., p. 296), that

“monetary shocks were just not pulling their weight: by removing all monetary aspects of the theory they obtained a far simpler and more comprehensible structure that fit postwar U.S. time series data just as well as the original version.”(9)

Lucas continues to see monetary contraction as the prime cause of the Great Depression, however, and thinks that the recent Great Recession was the result of financial shocks.
He told an interviewer (Lucas 2012):

Since I was convinced by Friedman and Schwartz that the 1929-33 down turn was induced by monetary factors (declines in money and velocity both) I concluded that a good starting point for theory would be the working hypothesis that all depressions are mainly monetary in origin.

[Then came Kydland and Prescott’s work.]

As I have written elsewhere, I now believe that the evidence on post-war recessions (up to but not including the one we are now in) overwhelmingly supports the dominant importance of real shocks.
But I remain convinced of the importance of financial shocks in the 1930s and the years after 2008.
Of course, this means I have to renounce the view that business cycles are all alike!

So the hypothesis that monetary policy matters for some business cycles remains alive.

(We will consider below the modern research that entertains a role for monetary policy in causing boom and bust.)

But note that Lucas in the above quotation cites only negative monetary shocks to account for the declines after 1929 and 2008, not overly expansive monetary policy to account for unsustainable booms in previous years.

This is consistent with the (seldom spelled out) Hayekian view of the effects of negative monetary shocks, but is also consistent with the Friedman “plucking model” interpretation (there are no booms above sustainable output, only dips below potential output followed by recoveries) of US business cycle data.

Friedman regarded this data as empirically falsifying the Austrian scenario of a boom followed by a bust.(10)

“Removing all monetary aspects” and focusing on common technology shocks certainly simplifies the model.

But it also colors the model. It means that instead of allowing different agents to have different price information sets in the short run, as in the Lucas (1981) “archipelago” approach, the model can employ a single representative agent who faces no information-processing problem.

As De Grauwe (2010) notes, part of Hayek’s critique of the idealized central planner model of the market socialists, as found in his classic essay “The Use of Knowledge in Society,” applies as well to the idealized representative agent who knows the model economy he populates well enough to always form model-consistent expectations.
Wrote Hayek (1945, p. 530):

To assume all the knowledge to be given to a single mind in the same manner in which we assume it to be given to us as the explaining economists is to assume the problem [of knowledge acquisition] away and to disregard everything that is important and significant in the real world.

2. Hayek and DSGE

Researchers in the New Classical or RBC branch of DSGE modeling today call their work “neoclassical modern macroeconomics” to distinguish it from work in the New Keynesian branch (Chari, Kehoe, and McGrattan 2009).

In doing so they collapse neoclassical economics to a Walrasian economics in which money is inessential.

Monetary shocks have so faded from interest that in most neoclassical DSGE models no variable for the money stock appears in the equation system (see below).

Monetary policy does no harm, and a change in monetary policy in response to a real shock can do no good because resulting movements in real output are optimal responses to real shocks.

About the only Hayekian memes left in neoclassical DSGE are the methodological dicta, in opposition to non-micro-founded Old Keynesian income-expenditure models, that a properly grounded theory of the business cycle
(1) posits price-guided agents and
(2) begins and ends in an intertemporal general equilibrium.

New Keynesian DSGE models share the intertemporal optimization and general equilibrium approaches of neoclassical DSGE models, but add price and wage “stickiness.”

Because the price stickiness feature of New Keynesian DSGE models allows monetary policy shocks to have cyclical real effects on output and employment, the models are in that respect substantively closer to monetary business cycle theories, whether of the Austrian variety (Mises, Hayek, and Garrison), the old Monetarist variety (Friedman and Yeager), or the recent Market Monetarist variety (Sumner and Beckworth), than are neoclassical DSGE models.

Accordingly Bennett McCallum (2014, p. 159), a Monetarist of long standing, finds it “appropriate that this analysis includes a price adjustment relationship (aka ‘Phillips curve’) that involves some sluggishness in prices, thereby imparting a non-trivial effect of monetary policy on the cyclical behavior of real output and employment.”
He adds:

“To exclude any such relationship,” as neoclassical DSGE models do, “would be to imply that an extreme tight money episode engineered by the central bank would not induce a recession—thereby suggesting that the [recession associated with the] Volcker Disinflation was just an accident.”(11)

Note that the real effects of monetary policy can only be of a Monetarist and not an Austrian variety (focusing on monetary disequilibrium rather than intertemporal disequilibrium) in a model that has no capital, and no channel for interest rate movements to alter investment decisions.

Roger Koppl (2014, p. 50) nicely encapsulates the makeup of both classes of DSGE models:

DSGE models are dynamic because they describe the behavior of an imaginary economy over time.
They are stochastic because some of the key variables of the model such as productivity and labour supply are subject to random shocks.
Finally, they are general equilibrium models because all markets are considered at once.

To discuss the character of DSGE models in more detail, I draw upon McCallum’s (2014, p. 158) specification of a “standard three-equation New Keynesian (NK) model” that is “highly representative of current mainstream analysis.”

The unknowns are real income, the inflation rate, and the nominal interest rate.
The model consists of
(1) an “expectational IS curve,”
(2) an expectations-augmented Phillips-type curve (relating the inflation rate not to the unemployment rate but to the real output gap), and
(3) an interest-rate-targeting Taylor Rule.

To quote McCallum’s exposition:

(1) yt = b0 + b1(Rt - Etπt+1) + Etyt+1 + vt b1 < 0
(2) πt = βEtπt+1 + κ(yt - t y ) + ut κ > 0
(3) Rt = μ0 + (1 + μ1)πt + μ2(yt - t y ) + et μ1 > 0

where the variables are
yt = [real] output,
πt = inflation rate, and
Rt = nominal one-period interest rate,
all expressed in terms of fractional deviations from steady-state values.
Etπt+1 represents the expected value at date t of the period t+1 inflation rate, and similarly for Etyt+1,
while t y represents flexible-price output, so that (yt - t y ) is the output gap.

Equation (1), like the ordinary IS curve of the IS-LM model, gives combinations of real output and the real interest rate consistent with savings-investment equilibrium.
Its microfoundations lie, in McCallum’s words, in
“the intertemporal Euler equation (for a typical infinite-lived household with standard time-separable preferences) with a linearized overall resource constraint plus the assumption that the economy-wide capital stock is fixed.”

Equation (2), the expectations-augmented Phillips Curve, derives from “the basic Calvo model of imperfectly flexible price setting.”

Equation (3) is “the central bank’s policy rule” for setting the one-period interest rate, in the form of a Taylor Rule.

McCallum notes that we can (if we want) think of the quantity of base money (not explicit in the above equations) as endogenous under a Taylor Rule, taking whatever value it needs to take (given an interest-sensitive base money demand function) to hit the interest rate target.
A monetary policy surprise enters the model as an unexpected deviation in the interest rate Rt associated with a shock to et in Equation (3).

Peter Howitt (2012, p. 13) specifies a nearly identical three-equation system as the common core of the New Keynesian DSGE models that are used by central banks “for projection and policy analysis.”

Such models are variations on “the canonical version presented masterfully by Woodford (2003).”(12)

Howitt sharply criticizes the rationale of Equation (1):
“The idea that the entire household sector of say the US economy is just a blown up version of a single person is on the face of it about as bold and unlikely a hypothesis as one could imagine,”
given the severe theoretical barriers to such an aggregation and abundant empirical evidence that such an aggregate Euler equation poorly fits the data.

John Driffill (2011, p. 1) also criticizes the single representative household construct. In such a model, he observes, there is no trade, in particular “no lending or borrowing.”
(The equilibrium interest rate is the rate that equates the representative household’s excess demand for loanable funds to zero.)
There is no explicit financial sector, let alone “default or bankruptcy” problems.
In such a model:

When the transversality condition (the assumption that the economy is on a path that will converge on a long-run steady state) holds, asset prices are determined by fundamentals.
The housing booms and busts of recent years, the boom and bust, cannot occur.

If it rules out distorted asset prices in this way, a DSGE model banishes the possibility of a Hayekian boom and bust sequence.

An economist who takes “informationally efficient asset pricing” to be a core theoretical proposition may think that Hayekians who talk of boom and bust must be assuming non-optimizing or irrational behavior, since rational behavior misinformed by distorted or disequilibrium prices is ruled out.

Former ECB board member Otmar Issing and co-author Volker Weiland (2013) have offered an interesting contrast between the approach of Hayek (1931) and that of DSGE pioneer Michael Woodford (2003), indicating Hayek’s continuing status as a touchstone for opponents of loose credit.

They note that Hayek (1931, pp. 26-27) rightly criticized Wicksell for the confusion of thinking that the establishing the rate of interest consistent with intertemporal equilibrium (the natural rate) also implies a constant price level.

Hayek showed that intertemporal equilibrium requires “not a constant price level, but the neutrality of money, i.e., the idea that money does not influence, that is to say distort relative prices, is the benchmark for the conduct of monetary policy.”

Issing and Weiland (2013,p. 425) argue that Woodford (2003) shares Wicksell’s confusion.

Yet “Hayek and his critique are not even mentioned.

As Woodford’s approach had such a big influence on monetary theory and policy recently, it might be interesting to resume this debate.”

We can restate the criticism in this way: In the three-equation core DSGE model, at full employment (zero output gap), the nominal interest rate generated by the Taylor Rule (with inflation-rate input from the Phillips Curve) is supposed to be consistent with savings-investment equilibrium on the expectational IS curve.

But this requires that the Taylor Rule calibration accurately captures the current real natural rate in the parameter μ0.

The problem of incorporating an accurate proxy for the (unobservable and shifting) equilibrium real rate into a Taylor Rule is well known (Laubach and Williams 2003).

In a recent working paper, Cúrdia et al. (2012, p. 24) comment that “it would be interesting to explore more realistic assumptions on the information available to policy makers when making their decisions, focusing in particular on the fact that the efficient real interest rate is not observable in practice, unlike in our model.”

Hayek well understood the problem of the natural rate’s non-observability.
For that reason even his ideal proposed monetary policy rules (see below) did not instruct the central bank to act as though they knew the natural rate.

Theoretical research on New Keynesian DSGE models has considered extensive modifications from the three-equation core version above.
The acknowledged “policy workhorse” model of Smets and Wouters (2007) incorporates seven equations and unknowns.

In a chapter on “DSGE Models for Monetary Policy Analysis” in the respected Handbook of Monetary Economics, in a subsection on “Monetary Policy and Inefficient Booms,” Lawrence J. Christiano, Mathias Trabandt, and Karl Walentin (2011), hereafter CTW, make modifications that open up the possibility of a monetary boom and bust scenario (though not exactly a Hayekian scenario absent a structure of production).

CTW (2011, p. 309) note that the pre-2007 New Keynesian “conventional wisdom,” for which they cite Bernanke and Gertler (2000), held that
“an asset price boom is basically a demand boom … driven by optimism about the future,”
which means that it bids up wages and inflation,
“automatically raises interest rates and helps to stabilize asset prices.”

The central bank thereby automatically dampens the boom.
In their own modified New Keynesian model, CTW consider the case of optimism about “cost saving new technologies” that leads “forward-looking price-setters” to reduce prices today.

In such a case, the Taylor-Rule-following central bank “reduces the interest rate in response to the fall in inflation” and thereby “overstimulates the economy.”

They argue that this is not “just an abstract example without any relevance” because “in fact, the typical boom-bust episode is characterized by low or falling inflation,” citing the boom of the 1920s.

In this way CTW reach results very similar to Hayek’s critique of price-level stabilization policy in the face of positive productivity shocks – a theme central to his business cycle theory (White 1999a) – without any apparent consciousness of the connection.(13)

Hayek (1928 [1984], pp. 92-93) argued that if production costs are expected to fall over time,
"the expectation that prices will not change [due to expansionary central bank policy] calls forth an excessive rise in output for the future"
(here Hayek appeals to a kind of nominal/real confusion).

In his cycle theory (Hayek 1931), an increase in the demand for loanable funds, due to fresh producer optimism about investments in cost-lowering technologies, calls for an equilibrating rise in the interest rate.

If the central bank pursues an expansionary monetary policy to keep the interest rate from rising (a fortiori if it were to lower the rate as CTW suppose), it will inadvertently hold the market rate below the rate consistent with intertemporal equilibrium, and will push the banking system to fund the initiation of more projects than can profitably be brought to fruition.

The central bank thereby “overstimulates the economy,” to use CTW’s phrase, fostering an unsustainable boom.

3. Hayek and Non-DSGE contemporary macroeconomics

Ricardo J. Caballero (2010, p. 87) has distinguished “the core” of modern macroeconomic research, meaning DSGE research, from non-DSGE research on “the periphery” of the profession.(14)

He tentatively suggests that the profession should consider “shifting resources from the current core to the periphery and focusing on the effects of (very) limited knowledge.”

Since the financial crisis of 2007-08, several established non-Austrian researchers in mainstream institutions have already begun the shift while referring to the Mises-Hayek business cycle theory as one inspiration.

Guillermo A. Calvo (2013, p. 56) observes:

There is a growing empirical literature purporting to show that financial crises are preceded by credit booms [citing Borio (2012) and others].
This was a central theme in the Austrian School of Economics (see Hayek [2008] and Mises [1952]).15 …
Borio and associates are carrying forward a research program that contains several elements akin to the Hayek/Mises mix.

Claudio Borio is Head of the Monetary and Economic Department at the Bank for International Settlements; William R. White, formerly at the BIS where he co-authored with Borio, is now at the OECD.
In a large set of thoughtful essays emphasizing the dangers of credit and asset-price booms, Borio, White, and co-authors (Borio, English and Filardo 2003; Borio and White 2004; Borio 2011; Borio and Disyatat 2011; Borio 2012; White 2006; White 2012) do repeatedly cite Hayek.

But they cite him as a historical forerunner who discussed credit booms, rather than taking building blocks from Hayek’s work to construct their own theory.

It should be noted that they also cite the very different credit-boom theory of Hyman Minsky, according to which the banking system becomes unstable on its own, without central bank help.16

Calvo himself, originator of the above-mentioned Calvo sticky-price mechanism used in DSGE models, shows surprisingly deep appreciation for Mises and Hayek’s business cycle theories.

He even recognizes a seldom-noted distinction between the two.
Mises consistently attributed the boom-initiating shock to unexpectedly expansive policy by a central bank trying to lower the market interest rate. Call this Scenario 1.

Hayek added two alternate scenarios.

In Scenario 2, already discussed above, fresh producer optimism about investment raises the demand for loanable funds, and thus raises the natural rate of interest, but the central bank deliberately prevents the market rate from rising by expanding credit.

In Scenario 3, in response to the same kind of increase the demand for loanable funds, but without central bank impetus, the commercial banking system by itself expands credit more than is sustainable.17)

Calvo correctly takes Scenario 1 to represent Mises’ view, and with some (but more limited) justification takes Scenario 3 to represent Hayek’s.

In a section of his paper sub-headed “Policy Mistakes and Imperfect Information: The Austrian School of the Trade Cycle Was on the Right Track,” Calvo (2013, p. 55) notes the role of relative-price effects in Hayek’s theory.

He judges Scenario 3, which he associates with bankers’ “perception errors,” plausible for most business cycle booms, but Scenario 1 more plausible for the 2002-07 boom:

Hayek’s discussion … implies that credit expansion is likely to have effects on relative prices that are not justified by fundamentals.

Shocks that impinge on relative prices are hardly discussed in mainstream close[d]-economy macro models.[fn. omitted] Hayek’s theory is very subtle and shows that even a central bank which follows a stable monetary policy may not be able to prevent business cycles and, occasionally, major boom-bust episodes.

Unfortunately, Hayek does not quantify the impact of perception errors (he was philosophically averse to quantification according to modern standards, see Hayek [1974]), and although I find the argument persuasive for regular business cycles, I think it would be quite a stretch to claim that they help to explain episodes such as the subprime crisis, unless we bring into the picture the hand of the central bank, as postulated by Mises.

Thus, I think the Hayek/Mises mix has a better chance of being close to the mark—with the emphasis on Mises for the current event.

Calvo (2013, pp. 55-56) also appreciates the Austrian warning that the distortion of a complex production structure during the boom rules out a “soft landing” afterward, and limits the power of an anti-recession stimulus policy to help.

When the downturn begins “the policymaker cannot possibly know where to operate due to the complexity of the situation.”

Accordingly “it is not hard to conclude that countercyclical policy may be largely ineffective—in the lucky case in which it is not outright counterproductive.”

4. Hayekian monetary policy norms in the recent literature

After Real Business Cycle theory, New Keynesian DSGE models with price and wage stickiness reinstated the possibility that an ideal monetary policy—always operating at the right time and in the right measure—can improve macroeconomic outcomes, i.e. dampen business cycles.

Some commentators consider this a “Keynesian” idea, but others (McCallum 2014, p. 162 n. 10) have observed that it was also an old Monetarist idea, where the old Monetarists include Milton Friedman, Leland Yeager, and others before Lucas who theorized about shocks having real effects in a Marshallian short run with sticky prices.

In Monetarist thinking, if the central bank were to vary the monetary base M0 so as to offset changes in the money multiplier M/M0 and thereby keep broader the broader money stock M (either M1 or M2) on a steady growth path, it would stabilize spending MV and thereby actual real output around the natural rate of real output.

If it would vary M so as to offset the effect of shocks to velocity V on spending MV (stabilize the “aggregate demand” curve in the textbook AD-AS model), it would likewise keep the economy at the natural rate of output.

Friedman’s classic critique of activist monetary policy was that central banks in practice had proven unable to meet the second of these criteria (he remained optimistic about meeting the first) because of “long and variable lags” in the central bank’s recognition and reaction to movements in velocity, and in economic agents’ spending response to a change in the trajectory of money growth.

The Fed had in fact amplified cycles by pursuing discretionary stop-go policy.

It followed in his view that the policy prescription for doing the least harm was that the central bank should give up trying to offset velocity shocks and should instead simply aim not to be a source of disturbance, by pursuing steady monthly growth in M2.

The possibility of macroeconomic improvement from an ideal monetary policy was also a Hayekian idea.

In the fourth lecture of Prices and Production, entitled “The Case For and Against an ‘Elastic’ Currency,” Hayek (1931, pp. 124, 123) argued that “any change in the velocity of circulation would have to be compensated by a reciprocal change in the amount of money in circulation if money is to remain neutral towards prices,” which implies that an ideal central bank would offset changes in the money multiplier or the velocity of money so as to stabilize “the volume of payments made during a period of time,” i.e. the equation of exchange’s MV and correspondingly nominal GDP.(18)

He rejected this as a practical norm on numerous grounds, however, beginning with the fact that in an open economy with international gold inflows and outflows (19) the central bank does not control the national M.

Instead, national M regulates itself through the price-specie-flow mechanism, conforming to shifts in the nation’s share of global real demand to hold money.

Hayek returned to this theme in a little-noted proposal for “A Regulated Gold Standard” in The Economist (Hayek 1935).

A global fall in the velocity of gold could be offset by an international agreement among central bankers, perhaps administered by the BIS, for each to increase the ratio of national central bank liabilities to gold. In a series of lectures published as Monetary Nationalism and International Stability, Hayek (1937, p. 93-4) elaborated on the ideal of “really rational regulation of the quantity of money” by “an effective international monetary authority” that would offset global changes in the money multiplier and velocity.

But so long as that system “remains an utopian dream,” Hayek preferred the greater predictability of “any mechanical principle (such as the gold standard) which at least secures some conformity of monetary changes in the national area to what would happen under a truly international monetary system” to the disturbances introduced by “numerous independent and independently regulated national currencies.”(20)

Neither Hayek’s first-best nor his second-best emerged from Bretton Woods in 1944.

Today—at least to judge by a recent survey of forty leading economists (21)—there are effectively no mainstream academic economists who defend a gold standard even as a second-best regime, so Hayek’s pragmatic defense of it does not currently exhibit any influence in the mainstream of the profession.

Hayek’s critique of monetary nationalism has, however, influenced noteworthy contemporary work in the political economy of international monetary relations by Benn Steil and Manuel Hinds (2009, pp. 96-101, 179; also Steil 2013, p. 340).

After his 1943 article endorsing a “Commodity Reserve Currency,” which has attracted little recent discussion, Hayek largely withdrew from monetary economics, which he has attributed to the profession’s enthusiasm over the Bretton Woods system.
He did include a littlenoted chapter on “The Monetary Framework” in The Constitution of Liberty (1960).

After receiving the Nobel Prize, Hayek returned to the monetary pool with a splash, publishing the monographs Choice in Currency (1976) and The Denationalisation of Money (1976, with a greatly expanded second edition in 1978).

The Denationalisation has been widely cited ever since in the theoretical policy literature on the competitive supply of money, which continues to show activity from time to time.

I will discuss two prominent examples (22).

Hayek’s work also continues to be cited in the applied policy debate over Eurozone centralization versus decentralized alternatives.
And most recently it has enjoyed attention in discussions about the policy implications of Bitcoin.

A prominent economist contributing to the theoretical policy literature on currency competition in the last twenty years is Michael Woodford (1995, p. 40), who surprisingly argues that a “fiscal theory of the price level” vindicates Hayek’s case for competition in the issue of fiat-type money.

The fiscal theory’s non-monetary determination of the equilibrium price level “confirms the claim by proponents of laissez-faire monetary arrangements that elimination of the government monopoly of money creation would serve to prevent inflation (e.g., Hayek, 1978).”

Of course, Hayek took it for granted that inflation was a monetary phenomenon.

Ramon Marimona, Juan Pablo Nicolinie, Pedro Teles (2012) have recently revisited the established (Taub 1985, White 1999c, ch. 12) point that a credible pre-commitment not to take the one-shot profit from hyper-expansion is necessary for private irredeemable to gain acceptance.
They ask:

Can currency be efficiently provided by competitive markets? A traditional laissez-faire view—as has been expressed, for example, by Hayek—based on Bertrand competition argues that competition drives the price of money to its marginal cost.
Therefore, if the marginal cost of producing currency is zero, competition drives nominal interest rates to zero and private provision of currency is efficient.

It is odd to call Hayek’s “a traditional laissez-faire view” when private non-commodity monies were not considered feasible before 1974.

Be that as it may, Hayek’s prediction was that free competition would drive inflation to zero, not the nominal interest rate to zero.

It was rather Benjamin Klein (1974) and later Neil Wallace (1983) who argued that free competition drives the spread between bond and currency interest rates to the marginal cost of intermediating bonds into interest-bearing currency.

If the marginal cost of producing interest-bearing currency is zero, then competition implies not zero nominal interest rates but a zero spread between the interest rates on currency and bonds, hence no interest opportunity cost of holding currency.

This is the condition required for achieving efficiency in currency holding also known as the Optimum Quantity of Money (Friedman 1969).
Hayek’s prediction implies (he did not spell out why) that consumers would prefer a stable-valued to an appreciating money.


Present-day mainstream macroeconomics is dominated by Walrasian (DSGE) models with restrictions added to generate Keynesian properties.

Although DSGE modelers have been trying to incorporate financial variables since the 2007 bust, distortions in the structure of capitalistic production remain almost entirely off the radar.

Not since Robert E. Lucas Jr. in the 1980s have monetary policy shocks been emphasized. Accordingly this research exhibits little of a Hayekian character.

Some researchers on the periphery of the mainstream, however, especially Claudio Borio and William R. White, have emphasized credit booms and recognized Hayek as a fore-runner.

In a recent opinion piece, Borio (2013) has called for models of the financial cycle that have the following features:

• The booms should not just precede but cause the busts: busts are fundamentally endogenous, the result of the vulnerabilities and distortions built up during the boom.
• The busts should generate debt and capital stock overhangs – the natural legacy of the preceding unsustainable expansion.
• And potential output should not just be identified with non-inflationary output: as the previous evidence indicates, output may be on an unsustainable trajectory even if inflation is stable.

To have these features, he argues, macroeconomic theories must

“capture more deeply the monetary nature of our economies: the banking sector does not just allocate given resources but creates purchasing power out of thin air.
In all probability, all this may require us to rediscover the merits of disequilibrium analysis.”

Provided only that “the banking sector” here is understood to include the central bank, this is a research agenda with a potentially strong Hayekian flavor.


1. I thank Patrick Newman and Scott Burns for research assistance, and participants at the Symposium on Current Hayekian Scholarship, Mercatus Center, Oct. 2014, for discussion.

2. Google Scholar records the following numbers of citations as of 1 September 2014:
“The Use of Knowledge in Society” 10,830;
The Road to Serfdom 6159;
Law, Legislation, and Liberty 6749.
By comparison:
Prices and Production 1337;
Denationalisation of Money 1031;
Monetary Theory and the Trade Cycle 656.

3. Who had drawn them largely from Eugen von Böhm-Bawerk, Knut Wicksell, and the Currency School.

4. Hayek is known among today’s video-watching students as the rapping cycle-theory opponent of Keynes, thanks to the YouTube hit “Fear the Boom and Bust,” created by John Papola and Russ Roberts.

5. There has also been a revival of interest in Hyman Minsky’s very different (Post Keynesian) ideas about financial instability.

6. Caldwell (2002 pp. 62-3) points out that Hayek made this argument in reply to Adoph Löwe. Löwe (1926) had claimed that standard “static” economic theory must be abandoned to explain business cycles. Hayek’s alternative view: we loosen the equilibrium-always character of "static” equilibrium theory as soon as we introduce money, neither a production nor a consumption good, creating what Hayek would later call a “loose joint.”

7. He did so (Lucas 1981) on the empirical grounds that the interest-elasticity of investment has been shown to be too small to account for the investment swings seen in business cycles, but did not identify where this had been shown.

8. Butos (1985), Scheide (1986), Kim (1988, p. 84), Hoover (1988), Ruhl (1994), Arena (1994), Garrison (1991), Dal-Pont and Hagemann (2005).

9. For an account of Lucas’ career, including this episode, see Michel De Vroey (2010).

10. For a critical account of Friedman’s “plucking model” see Garrison (1996). For econometric support of the model see Kim and Nelson (1999).

11. This again is consistent a plucking-model viewpoint.

12. To “improve its ability to fit the data” (in the words of Cúrdia et al. 2012), central bank economists commonly supplement “the purely forward-looking textbook New Keynesian framework” with backward looking variables, aka “sources of inertia,” such as lagged inflation. As Howitt (2013, p. 13) points out, adding ad hoc variables to the right hand sides of a model’s equations to make them better fit the data “raises the question of whether they have been over fitted.”

13. CTW do not cite Hayek. They do in this subsection cite the empirical results of Adalid and Detken (2007), who in turn cite Borio, English, and Filardo (2003); Borio and White (2004); and White (2006); three papers that do explicitly refer to Hayek (1929) or Hayek (1931).

14. Caballero notably criticizes DSGE-focused researchers for pursuing a “process of makebelieve substitution” of calibrated models for reality that “raises our presumption of knowledge about the workings of a complex economy and increases risks of a ‘pretense of knowledge’ about which Hayek warned us.”

15. “Hayek [2008]” is a citation to Prices and Production; “Mises [1952]” to The Theory of Money and Credit.

16. In an unpublished paper on the 1920s credit boom, Eichengreen and Mitchener (2003) cite works by Mises, Hayek, and Lionel Robbins, but also the very different view associated with Minsky and Charles Kindleberger.
They even lump the two together, referring (p. 32) to a “Minsky-Kindleberger-Robbins-style interpretation of the Great Depression as a credit boom gone wrong.”

17. For an immanent critique of Scenario 3, see White (1999b).
In short, S3’s systemic unforced errors are inconsistent with the equilibrating role of the price system that Hayek described so well in “The Use of Knowledge in Society.”

18. Hayek is sometimes cited as a predecessor by Market Monetarists who argue for the central bank to target nominal GDP. But due to his emphasis on avoiding disruptive money-injection effects, Hayek clearly preferred a flat path for NGDP in a closed economy with a constant population, and thus deflation with growth in real income, not a path rising at 4% or 5% per year.

19. Britain was still on the gold standard when Hayek delivered his lectures in February 1931, not departing it until September 1931.

20. For Hayek’s role in debates over postwar international monetary reconstruction, see Endres (2005).

21. A poll of the IGM Forum Economic Experts Panel (2012) found the 37 panelist who responded in unanimous disagreement (some strongly) with a statement proposing that returning to a gold standard would improve economic outcomes.
The poll is also cited by Daniel Drezner (2012, p. 221). Two panelists (Daron Acemoglu and Edward Lazear) did soften their rejection of a gold standard with remarks referring to its value as a constraint on policy.

22. Endres (2009) argues persuasively for reading Denationalisation not only as theory or policy in the abstract, but for its positive analysis of inter-government currency competition in today’s world.


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