Mr. Hayek and the Classics: A Suggested Interpretation of the Business Cycle Theory in Prices and Production

This paper endeavors to develop a modern theoretical underpinning of Friedrich August von Hayek’s business-cycle theory as published during the Great Depression in his book Prices and Production. According to Hayek, economic cycles are caused by monetary shocks, which distort the relative-price schedule across economic sectors. Possible consequences of these price distortions, which are also called “Cantillon effects,” include malinvestment and an unsustainable production structure, which sooner or later has to be corrected by a recession. It turns out that this type of economic fluctuation can be condensed into a simple two-sector overlapping generations model.