Hayek’s assumption of a real world full employment equilibrium state is confirmed in a letter that Hayek wrote to John Hicks in 1967, regarding the assumptions of his theory, where Hayek confirms that his theory required equilibrium and full employment as the initial stage at the beginning of the process leading to the trade cycle:
Hicks to Hayek, November 27, 1967“... We have (a) full employment, (b) static expectations, (c) ‘equilibrium’ at every stage, so that demand = supply in every market, prices being determined by current demand and supply. Add to these the Wicksell assumption, of a pure credit economy and we clearly find that if there were no lags, the market rate of interest cannot be reduced below the natural rate in an equilibrium position; ....Moreover, Hayek, on pages 265–266 of Prices and Production, explicitly tells us his purpose in the book:
Hayek to Hicks, December 2, 1967
I accept assumption (a), full employment. I am not sure that I quite know what (b) ‘static expectations’ means, but if it means that at each stage of the process everybody acts in the expectation that future prices will be the same as present prices, I accept that too – though we shall see that these expectations must be disappointed.
Of (c) I can accept that at each stage in every separate market demand = supply in the sense that at the ruling price all buyers and sellers buy and sell as much as they want to buy at that market, but not in the sense that any change in the supply which a change in price will bring about in the course of time has already taken place or that prices correspond to the marginal costs at which producers now begin to produce.
Nor need there [be] at any but the initial stage an overall equilibrium between the different markets, because a change of price necessary to secure equality between demand and supply in any one market will make at the next stage a change of other prices inevitable as a result of the changed receipts in the first market being spent.
Let us now start with a system in full stationary equilibrium: constant prices and no net saving or investment and no changes in the supply of factors or tastes and a constant flow of money (which may be a token or partly credit money) ... (Hayek 1999: 100–102).
“My present task is to fill in the details of that rough sketch and to show what happens in the interval before a new equilibrium is attained.” (Hayek 2008: 265–266).If Hayek thought at this stage in his career that equilibrium states can never occur in the real world, then what was point of his trade cycle theory?
Hayek, F. A. von, 1999. Collected Works of F.A. Hayek, Volume 6: Good Money, Part II: The Standard, Routledge, London.
Hayek, F. A. von, 2008. Prices and Production and Other Works: F. A. Hayek on Money, the Business Cycle, and the Gold Standard, Ludwig von Mises Institute, Auburn, Ala.