The Review of Austrian Economics, 14:4, 319–330, 2001.
2001 Kluwer Academic Publishers. Manufactured in The Netherlands.
Expectations in Austrian Business Cycle Theory: An
Application of the Prisoner’s Dilemma
ANTHONY M. CARILLI email@example.com
Associate Professor of Economics, Department of Economics, Hampden-Sydney College, Hampden-Sydney,
GREGORY M. DEMPSTER firstname.lastname@example.org
Assistant Professor of Economics, Department of Economics, Hampden-Sydney College, Hampden-Sydney,
Abstract. The standard account of Austrian Business Cycle theory posits that central bank manipulations of
interest rates fool bankers and investors into believing that there has been an increase in the real supply of loanable
funds available for capital investment. However, reliance on “foolishness” ignores the entrepreneurial emphasis
within the Austrian tradition and fails to produce the strongest possible case for Austrian Business Cycle theory.
We use the prisoner’s dilemma framework to model the proﬁt maximizing behavior of bankers and the investors
under uncertainty when the market rate of interest is below the underlying rate of time preference.
JEL classiﬁcation: E30, E50.
The standard account of the Mises-Hayek theory of cyclical ﬂuctuations, also known as
Austrian Business Cycle Theory, posits an increase in bank reserves, created by a central
bank, that drives a wedge between nominal savings available for investment and real savings
based on the time preference schedules of market participants. This increase in nominal, as
opposed to real, savings is characterized by a market rate of interest that is held below the
natural rate due to the process of money expansion. An artiﬁcial boom develops, driven by
a temporary increase in investment spending, but is doomed to eventual failure because of
the lack of real savings (i.e. resources) to sustain it. Thus, an inevitable bust occurs as ﬁrms
are forced to revise their investment plans.
This version of ABC theory, originally proposed by Mises [1971 (1912)] and further de-
veloped by Hayek (1933, 1935, 1939) and Garrison (1986, 1989), among others, has some
important strengths. Perhaps its foremost strength is the explicit recognition of the institu-
tional characteristics of the credit system and their importance on the macroeconomic level.
Central to the traditional ABC theory is the particular manner in which money is injected
into the credit system of the modern economy, giving rise to the relatively large swings in
investment spending that characterize most cyclical ﬂuctuations in business activity.
Despite numerous (and enlightened) attempts at development, however, the traditional
account continues to suffer from many shortcomings. Most of these shortcomings can
be subsumed into three categories: (1) problems involving the formation of expectations