Hayek explaination

Under a fractional reserves system, it is possible for the banking system to supply resources to entrepreneurs for investment in excess of resources that are voluntarily saved even at full employment through a process of forced saving. Since commercial banks are essentially profit making institutions, they expend their loans when excess reserves accrue to them. When banks expand their lending operations through credit creation. They lower the market rate of interest below the nature rate of interest the rate at which the demand for and the supply of real savings are equal and entrepreneurs are lured into utilising the artificially created banks credit to wean away resources from consumer goods industries. The resultant increase in the prices of consumer goods reduces the real income and consumption of the community forcing it to save.

The inflationary boom caused by this process of artificial credit creation can last only as long as the low market rate of interest can prevail in the economy. However as due to increase in investment outlay consumers money incomes rise their spending on the purchase of consumption goods increases raising the prices of consumer goods further. In the process the production of consumer goods becomes more profitable and entrepreneurs indulge in competitive bidding to suck away resources from investment goods to consumption goods production. This tendency continues as long as bank continue to expand credit. However the capacity of the banks to create credit is by no means limitless. As their reserves deposits ratio falls in the process of credit creation. They curtail further lending and the market rate of interest rises. At the higher market rate of interest many of the new investment projects that were deemed profitable when the market rate of interest was low become unprofitable and have to be abandoned. A vertical maladjustment overtakes the economy and recession sets in.

Hayek has explained the extraordinary cyclical fluctuations in the production of capital goods under the assumption of the full employment and constant real income. In real life, the typical recession is, however, marked by unemployment resources making it possible for the simultaneous expansion of consumption and capital goods in the economy. The increase in the production of investment goods in greater proportion than consumption is explained by the fact that in the short period the percentage of income spent on consumption falls as income increase .

Its severe limitations notwithstanding, Hayek theory explains that the actions of the banking system could sustain a boom and that a boom that was artificially so sustained could make the recession that follows the boom all the more serious if investment was made in those lines where no true long run profit prospects existed.