Sunday, June 22, 2014

Keynes and IS-LM

Updated

Did Keynes accept the IS-LM model?

Harcourt and Turnell (2012a [2005]: 35) argue that Roy F. Harrod, James E. Meade, W. Brian Reddaway and David Champernowne all found a type of IS-LM model in the General Theory.

This is an interesting subject, and a starting point is the discussion in King’s A History of Post Keynesian Economics since 1936 (2002), pp. 30–32.

First, King notes that Keynes’ heart attacks and his burden of work related to the Second World War stopped him from making systemic, point-by-point responses to all the controversy caused by the General Theory (King 2002: 30).

Others have noted that Keynes’ response to interpretations of the General Theory was to encourage and support any favorable treatments as a pragmatic and tactical move.

King notes that Keynes “never once repudiated the IS-LM interpretation of the General Theory” but “endorsed it warmly” (King 2002: 31), although Kriesler and Nevile have pointed out in their paper “IS-LM and Macroeconomics after Keynes” (Kriesler and Nevile 2002) that the early IS-LM models of Roy Harrod and W. B. Reddaway were not exactly the same as that of John Hicks (1937).

Although it can be disputed that any of these data actually show Keynes specifically endorsing IS-LM without reservation, nevertheless he did not explicitly reject it either, and King lists the following evidence:
(1) a letter to Roy Harrod in August 1936
Keynes wrote a letter on 30 August 1936 to Roy Harrod, commenting on Harrod’s paper “Mr. Keynes and Traditional Theory,” Econometrica 5.1 (1937): 74–86.

Keynes said this:
“My dear Roy,

I like your paper (may I keep the copy you have sent me?) more than I can say. I have found it instructive and illuminating, and I really have no criticisms. I think that you have re-orientated the argument beautifully. I also agree with your hints at the end about future dynamic theory.

I am reading a paper to the economic club at Stockholm on about the same date as you will be reading this, and have been thinking (it isn’t written yet) of trying to pick out what I thought most important. But I now feel that I should like to read them your paper instead! There are, however, one or two points mainly omitted in yours which I should be inclined to put into mine:--

(1) I have been much pre-occupied with the causation, so to speak, of my own progress of mind from the classical position to my present views,--with the order in which the problem developed in my mind. What some people treat as an unnecessarily controversial tone is really due to the importance in my own mind of what I used to believe, and of the moments of transition which were for me personally moments of illumination. You don’t feel the weight of the past as I do. One cannot shake off a pack one has never properly worn. And probably your ignoring all this is a better plan than mine. For experience seems to show that people are divided between the old ones whom nothing will shift and are merely annoyed by my attempts to underline the points of transition so vital in my own progress, and the young ones who have not been properly brought up and believe nothing in particular. The portholes of light seen in escaping from a tunnel are interesting neither to those who mean to stay there nor to those who have never been there! I have no companions, it seems, in my own generation, either of earliest teachers or of earliest pupils; yet I cannot in thought help being somewhat bound to them,--which they find exceedingly irritating!

(2) My second point is, perhaps, part of my first. You don’t mention effective demand or, more precisely, the demand schedule for output as a whole, except in so far as it is implicit in the multiplier. To me the most extraordinary thing, regarded historically, is the complete disappearance of the theory of demand and supply for output as a whole, i.e. the theory of employment, after it had been for a quarter of a century the most discussed thing in economics. One of the most important transitions for me, after my Treatise on Money had been published, was suddenly realising this. It only came after I had enunciated to myself the psychological law that, when income increases, the gap between income and consumption will increase,--a conclusion of vast importance to my own thinking but not apparently, expressed just like that, to anyone else’s. Then, appreciably later, came the notion of interest being the measure of liquidity-preference, which became quite clear in my mind the moment I thought of it. And last of all, after an immense lot of muddling and many drafts, the proper definition of the marginal efficiency of capital linked up one thing with another.

(3) You do not show how in conditions of full employment, which I should now like to define as the limiting case in which the supply of output schedule ceases to be elastic, my theory merges in the orthodox theory.

I should much like to have your paper for the … [Economic Journal]. My only ground for hesitation is the personal embarrassment of how much space as editor I can properly give to discussions of my own stuff. In December I am expecting something from Ohlin. Would next March be too late from your point of view?”

581. J. M. Keynes to Harrod, 30 August 1936
http://economia.unipv.it/~dbesomi/edition/editionstuff/rfh.271.htm#18792
Given that Roy Harrod is sometimes credited with anticipating the IS-LM model of Hicks, Keynes’ praise is suggestive, and Barens (1999) argues that Harrod’s model in “Mr. Keynes and Traditional Theory” was a correct interpretation of the model in Chapter 18 of the General Theory.

The Post Keynesians Harcourt and Turnell (2012a [2005]: 35) agree that a type of IS-LM model really is to be found there, and so does Matias Vernengo, who argues that IS-LM “is a reasonable representation of some ideas in … [Chapter 18], in particular because Keynes was unable to shed some of his neoclassical ideas.”

But, as other Post Keynesians have pointed out, in Chapter 18 of the General Theory, Keynes played down the role of uncertainty (which he had stressed in Chapter 12) and, if he had really maintained the crucial role of uncertainty, as he did later in his fundamental article “The General Theory of Employment” (1937), this would have “ruled out any stable functional relationship between investment and the interest rate” (King 2002: 14).

That the door was thereby left open in Chapter 18 for neoclassical synthesis Keynesians to reformulate the General Theory as a general equilibrium model like IS-LM where the interest rate has a pivotal role, as King (2002: 14) notes, does not mean that either Chapter 18 or IS-LM is compatible with other aspects of Keynes’ thinking.

It is, furthermore, interesting to note that Kriesler and Nevile (in “IS-LM and Macroeconomics after Keynes,” pp. 4–5) argue that Harrod’s model in “Mr. Keynes and Traditional Theory” was not quite the same as that of Hicks, but has a number of differences, not least of all that Harrod’s was not a clear-cut Walrasian general equilibrium model and also that Harrod did discuss expectations, unlike Hicks.

(2) an August 1936 letter to W. Brian Reddaway
In 1936, W. B. Reddaway published a review of the General Theory (“General Theory of Employment, Interest and Money,” Economic Record 12 [1936]: 28–36).

In a footnote, Reddaway produced a model that is fundamentally similar to Hicks’ IS-LM, but Keynes in a letter to Reddaway (Keynes 1973: 70) seems to have had no specific objections to it or the review generally (Harcourt 2012b [2004]: 295).

However, Kriesler and Nevile (in “IS-LM and Macroeconomics after Keynes,” p. 5) note that Reddaway’s model has a much greater role for expectations and uncertainty than Hicks’, and “can be read as consistent with either a Marshallian or Walrasian approach.”

(3) a letter to John Hicks in 31 March, 1937
In a letter commenting on a draft of J. R. Hicks’ famous paper “Mr. Keynes and the ‘Classics’; A Suggested Interpretation” (Econometrica 5.2 [1937]: 147–159), where IS-LM was developed, Keynes did not reject the model, but said that “I found it very interesting and really have next to nothing to say by way of criticism” (Keynes 1973: 79).

Unfortunately, I have not had the time to chase up and read the full copy of Keynes’ letter. Some have actually argued that Keynes’ reaction to Hicks’ paper was only “lukewarm” (Kriesler and Nevile, “IS-LM and Macroeconomics after Keynes,” p. 4). Others think that Keynes did have reservations about the ability of the model to represent the crucial role of expectations.

(4) an article responding to Dennis Robertson
Keynes (1938) replied to an article by Robertson (1938) in the Economic Journal, and on p. 321, note 1, he said this of Oskar Lange’s analysis of the General Theory in Lange’s “The Rate of Interest and the Optimum Propensity to Consume” (Economica n.s. 5.17 [1938]: 12–32):
“In this connection Mr. Robertson refers with approval to an article by Dr. Lange which follows very closely and accurately my line of thought. The analysis which I gave in my ‘General Theory of Employment’ is the same as the ‘general theory’ explained by Dr. Lange on p. 18 of this article, except that my analysis is not based (as I think his is in that passage) on the assumption that the quantity of money is constant.” (Keynes 1938: 321, n. 1).
Lange’s article “The Rate of Interest and the Optimum Propensity to Consume” (1938) was the first serious application of the IS-LM model (King 2002: 103).

(5) Keynes’ implicit support for Kaldor’s use of IS-LM in a 1937 article
In Pigou (1937), the latter defended the real balances effect against Keynes, and Kaldor (1937) was a response to this.

Keynes published Kaldor’s paper in the Economic Journal, and on p. 752–753, footnote 2, Kaldor used Hicks’ IS-LM model: Keynes did not seem to object to the use of this model.
As King (2002: 31) notes, the problem with all this is that it sits uncomfortably with Keynes’ later thinking on uncertainty and expectations, particularly in his 1937 article “The General Theory of Employment” (Quarterly Journal of Economics 51.2: 209–223).

Moreover, at the same time that Keynes was praising the IS-LM interpretation of the General Theory, he also endorsed the emerging heterodox interpretations of it too (King 2002: 32). If Keynes was also supporting non-general equilibrium interpretations of the General Theory, then there is a clear problem with saying that Keynes gave some explicit and consistent support for IS-LM.

One can only conclude that Keynes gave mixed signals on this subject and his thinking was not entirely coherent. But this can also be said of the General Theory itself.

Kriesler and Nevile have an interesting view on why Keynes did not explicitly reject IS-LM models:
“Only one question needs to be answered to make the case complete. Why did Keynes give it [sc. the IS-LM model] his cautious approval in 1937?

The major reason is certainly the clear cut position in IS-LM that it is effective demand that determines the level of employment not the balancing, at the margin, of the utility of wages against the disutility of work. It rejects Pigou’s theory of employment and Say’s law, against which Keynes was crusading. A second reason is probably that it showed the effects of changes in the quantity of money on the real economy. As Keynes pointed out, in the letter to Hicks already quoted, a strict classical economist would not admit that a change in the quantity of money could have any effect on the level of employment or any other real variable. Keynes argued strongly that it could. He stressed that the rate of interest, which had a key impact on output and employment, was a monetary phenomenon (1936, Chap.13, 1973, p.80). He would surely have welcomed support for this in IS-LM.”
Kriesler, Peter and John Nevile. “IS-LM and Macroeconomics after Keynes,” p. 7.
http://www.asb.unsw.edu.au/schools/economics/Documents/P.%20Kriesler%20and%20J.%20Nevile%20-%20IS-LM%20in%20Macroeconomics%20After%20Keynes.pdf
A final point to be borne in mind is that, while many Post Keynesians think IS-LM is worthless (and indeed the problems with it are devastating), others (who may well be in a minority) argue that a suitably reformulated IS-LM model has some analytical value: Harcourt and Turnell (2012a [2005]: 35) argue that a type of IS-LM model can capture “Keynes’s most abstract model in which short-term expectations and long-term expectations are assumed to be independent of one another, and short-term expectations are assumed to be realised immediately ... .” (Harcourt and Turnell 2012a [2005]: 35). Of course, one would assume that such an abstract model does not really describe the real world, but is an analytical tool only.

Note
Finally, does anyone know where there is an online complete copy of Keynes’ letter to John Hicks, 31 March, 1937, in which Keynes discusses the draft of J. R. Hicks’ famous paper “Mr. Keynes and the ‘Classics’; A Suggested Interpretation” (Econometrica 5.2 [1937]: 147–159)?

Update
Lars Syll has an impressive list of problems with IS-LM in the post below, and his conclusion is that it is “difficult to see how and why Keynes in earnest should have ‘accepted’ Hicks’s construct”:
Lars Syll, “Did Keynes accept the IS-LM Model?,” 22 June, 2014.
Links
Matias Vernengo, “ISLM: A Further Explanation and a Defense,” Naked Keynesianism, December 1, 2013.

Matias Vernengo, “ISLM: what is it good for?,” Naked Keynesianism, February 16, 2011.

Lars Syll, “IS-LM is bad Economics no matter what Krugman says,” Real-World Economics Review Blog, March 20, 2013.

Lars Syll, “IS-LM vs. Minsky,” 25 March, 2014.

Lars Syll, “Krugman’s vindication of the IS-LM gadget — brilliantly silly,” 27 March, 2014.

Bill Mitchell, “The IS-LM framework – Part 1,” Billy Blog, July 26, 2013.

Steve Keen, “Krugman’s Economic Modelling Morass,” Business Spectator, 7 March 2013.

Steve Keen, “Where Krugman went wrong,” Business Spectator, 8 March 2013.

Steve Keen, “How Krugman lost equilibrium,” Business Spectator, 13 March 2013.

Steve Keen, “Oblivious to the essence of equilibrium,” Business Spectator, 14 March 2013.

Steve Keen, “Modelling Economic Balance like it’s 1975,” 27 March 2013.

“Misinterpretations in Mainstream Economics,” February 19, 2013.

“Debunking Economics, Part VIII: Macroeconomics, or Applied Microeconomics?,” August 26, 2012.

BIBLIOGRAPHY
Barens, I. 1999. “From Keynes to Hicks – An Aberration? IS-LM and the Analytical Nucleus of the General Theory,” in Peter Howitt et al. (eds.), Money, Markets and Method: Essays in Honour of Robert W. Clower. Edward Elgar, Cheltenham UK.

Cord, Robert. 2013. Reinterpreting the Keynesian Revolution. Routledge, London.

Dillard, Dudley. 1990. “Interpreting Mr. Keynes: The IS-LM Enigma,” History of Political Economy 22.3: 582–584.

Harcourt, Geoffrey Colin and Sean Turnell. 2012a [2005]. “On Skidelsky’s Keynes,” in Geoffrey Colin Harcourt, On Skidelsky’s Keynes and Other Essays: Selected Essays of G.C. Harcourt. Palgrave Macmillan, New York. 13–58.

Harcourt, Geoffrey Colin. 2012b [2004]. “Reddaway, [William] Brian, 1913–2002,” in Geoffrey Colin Harcourt, On Skidelsky’s Keynes and Other Essays: Selected Essays of G.C. Harcourt. Palgrave Macmillan, New York. 294–304.

Harrod, R. F. 1937. “Mr. Keynes and Traditional Theory,” Econometrica 5.1: 74–86.

Hicks, J. R. 1937. “Mr. Keynes and the ‘Classics’; A Suggested Interpretation,” Econometrica 5.2: 147–159.

Kaldor, Nicholas. 1937. “Prof. Pigou on Money Wages in Relation to Unemployment,” The Economic Journal 47.188: 743–753.

Keynes, John Maynard. 1937. “The General Theory of Employment,” Quarterly Journal of Economics 51.2: 209–223.

Keynes, John Maynard. 1938. “Mr. Keynes and ‘Finance,’” The Economic Journal 48.190: 318–322

Keynes, John Maynard. 1973. The General Theory and After. Part II: Defense and Development. The Collected Writings of John Maynard Keynes. Vol. XIV. Macmillan London and Basingstoke.

King, J. E. 2002. A History of Post Keynesian Economics since 1936. Edward Elgar Publishing, Cheltenham, UK and Northampton, MA.

Kriesler, Peter and John Nevile. 2002. “IS-LM and Macroeconomics after Keynes,” in Philip Arestis, Meghnad Desai, and Sheila Dow (eds.), Money, Macroeconomics and Keynes: Essays in Honour of Victoria Chick, Volume One. Routledge, London and New York.

Kriesler, Peter and John Nevile. 2002. “IS-LM and Macroeconomics after Keynes.”
http://www.asb.unsw.edu.au/schools/economics/Documents/P.%20Kriesler%20and%20J.%20Nevile%20-%20IS-LM%20in%20Macroeconomics%20After%20Keynes.pdf

Lange, Oskar. 1938. “The Rate of Interest and the Optimum Propensity to Consume,” Economica n.s. 5.17: 12–32.

Moggridge, D. E. 1976. John Maynard Keynes. Penguin Books, New York.

Pigou, A. C. 1937. “Real and Money Wage Rates in Relation to Unemployment,” The Economic Journal 47.187: 405–422.

Reddaway, W. B. 1936. “General Theory of Employment, Interest and Money,” Economic Record 12: 28–36.

Robertson, D. H. 1938. “Mr. Keynes and ‘Finance,’” The Economic Journal 48.190: 314–318.

Young, Warren. 1988. “Interpreting Mr Keynes: The IS-LM Enigma,” The Economic Journal 98.389: 214–216.

10 comments:

  1. First of all, I think that this is only vaguely interesting from the point-of-view of the history of thought which should never be a "he said, she said". That is really a secondary issue.

    Secondly, put yourself in Keynes' shoes. You've just written a book that overturns previously held theories. You have a close group of (very young) supporters around you, you also have the majority of (established) hostile critics and then you have a few people who seem somewhat sympathetic. What are you going to focus on? Are you really going to start attacking those that are building little interpretations of your work that are not fully in line with what you are saying? You would be a fool.

    Thirdly, I think the 1937 article shows quite clearly that Keynes was getting very annoyed that people were ignoring the uncertainty argument and how it tied in with liquidity preference. The tone of that article is very much so that of a stern teacher who is sick of the otherwise eager pupil not understanding what had been said.

    Fourthly, we know how testy Keynes was that his theory should not be read as a 'sticky wages' argument (see: Chapter 19). Given that this was Hicks' interpretation we can only assume that Keynes' reception was due to diplomacy on his part in attempting to convince other people about his theory.

    Fifthly, and most importantly, one of the key objections today to the ISLM is that it has completely misconstrued the best part of the General Theory. Keynes could not have known this was going to happen just after he had written his major work. It is only in retrospect that we can see how badly it has distorted the key arguments in his work.

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    1. Sorry, this -- for some unexplained reason -- went into my spam filter!

      Didn't see it until today!

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    2. "Given that this was Hicks' interpretation we can only assume that Keynes' reception was due to diplomacy on his part in attempting to convince other people about his theory."

      Yes, and there is even evidence he was critical of Hicks in private letters:

      http://socialdemocracy21stcentury.blogspot.com/2014/06/keynes-letters-to-john-hicks-and-is-lm.html

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  2. I don't know if I have commented on your blog before, so let me start with a very warm thanks for your excellent blog. A lot of work must go into it and, as far as I can see it's all out of the goodness of your heart. Really, your posts are always a treasure trove of information and insight! Thank you!

    A slight and wholly secondary correction/addition: there is, in fact, a fifth article in Steve Keen's series on IS-LM and Krugman, here: http://www.businessspectator.com.au/article/2013/3/27/economy/modelling-economic-balance-its-1975 In it, Keen acknowledges that he made a crucial, if elementary, mistake in his critique of Krugman, misreading one of Krugman's diagrams, as explained in this post http://psichraimia.wordpress.com/2013/03/20/steve-keen-has-blundered-mores-the-pity/ on a now abandoned blog. Keen left a comment underneath denying that he made a mistake but, obviously, he thought better about it and starts his 5th piece with acknowledging his mistake ("my bad"). Although his mistake was unfortunate, in that he represented Krugman as making elementary mistakes, his deeper critiques still hold, I think.

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    1. Thanks -- I have added Steve Keen's fifth article on IS-LM.

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  3. Keynes didn't fight with people in public who were distorting his message but generally accepting his new approach. Shock!

    "It has been thoroughly argued that one of the reasons for the widespread and initially unopposed acceptance of the early ‘synthetic’ interpretations of the ‘General Theory’ was the strategic choice of the ‘reconcilers’, who wished for a theoretical truce with neoclassical economics in order to concentrate on the urgent policies needed to combat the Great Depression. Keynes did not cam- paign against such choices, although he resisted them in some private letters and argued for a radical interpretation of his message, at least in the paper that he wrote for the Quarterly Journal of Economics in 1937." (p184)

    http://digamo.free.fr/econolouc2.pdf

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  4. Keynes's followers saved Keynes's theory by introducing the IS-LM model.

    Keynes essentially derived the IS curve in the General Theory: "The one diagram that we do find in the General Theory (p. 180) is logically equivalent to the IS curve” (Patinkin 1990: 69).

    However, Keynes did not derive the LM curve. Keynes argued that the interest rate is determined by the supply and demand for money. Then Keynes made the demand for money a function of income. The fact that Keynes made money demand a function of income rendered the interest rate indeterminate.

    Keynes’s liquidity preference theory “is indeterminate because the liquidity-preference schedule will shift up or down with changes in the income level…. In the Keynesian case the money supply and demand-schedules cannot give the rate of interest unless we already know the income level … Keynes' criticism of the classical theory applies equally to his own theory. (Hansen 1953: 141).

    Keynes saw that the loanable funds theory was indeterminate in his theory, but he did not realize the liquidity preference theory was also indeterminate.

    Keynes's followers pointed out that the liquidity preference theory was indeterminate. They pointed out that money demand and the money supply cannot determine the interest rate. Instead, money demand and money supply only tell us what the interest rate will be at different levels of income. In short, they used the liquidity preference theory to derive the LM curve.

    The interest rate and the level of income are determined together at the point where the IS and LM curves intersect.

    It's important to consider the chronological stages of Keynes's development of the General Theory. The following time line is quoted from Gordon Fletcher (2009: 197):

    1. By May 1932: the consumption function (the fundamental psychological law)

    2. Summer 1932: effective demand - the supply and demand for output as a whole

    3. October 1932: the rate of interest and the liquidity preference theory

    4. much later: the marginal efficiency of capital

    In a 1937 letter to Harrod, Keynes wrote:

    "the initial novelty lies in my maintaining that it is not the rate of interest, but the level of incomes which ensures equality between saving and investment. The arguments which lead up to this initial conclusion are independent of my subsequent theory of the rate of interest, and in fact I reached it before the latter theory. But the result was to leave the rate of interest in the air" (Keynes)

    Keynes's followers saved Keynes's theory by introducing the IS-LM model. However, as the Post Keynesians point out, the IS-LM model is flawed.

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    1. These comments are getting ever more bizarre and confused... They're beginning to remind me of Michael Emmett Brady.

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    2. Yes, one wonders how "Keynes's followers saved Keynes's theory by introducing the IS-LM model" if the "IS-LM model is flawed".

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  5. "Yes, one wonders how "Keynes's followers saved Keynes's theory by introducing the IS-LM model" if the "IS-LM model is flawed".

    There is nothing bizarre or contradictory in claiming that (1) Keynes's theory was saved by his followers and (2) the IS-LM model is flawed.

    1. Keynes's theory was saved by his followers.

    Keynes gave an indeterminate interest rate theory. In the General Theory (p. 199), Keynes made the interest rate a function of income. Hicks and Hansen realized this made Keynes's liquidity preference theory of the interest rate indeterminate.

    "Keynes, unlike his predecessors, had all the elements in his theory to produce a determinate solution but that he never brought them together” (Fletcher 1987, p. 133)

    Keynes's followers brought these elements together and thereby salvaged the General Theory. They made Keynes's theory appear plausible.

    2. The IS-LM model is flawed.

    Post Keynesians know all the reason the IS-LM model is flawed. There's no reason to comment on this.

    Keynes's Treatise on Money was flawed. Patinkin argues reading the Treatise on Money is a waste of time:

    "I can (from the viewpoint of macroeconomic theory) see little profit (and certainly no pleasure) in reading it today.... it is not a good book" (Patinkin 1976: 25)

    Like the Treatise on Money, the General Theory was a flawed book. However, economists still read it because Keynes provided all the elements required for a determinate (but pseudoscientific) theory of interest and income.

    Keynes's followers saved the General Theory because "Keynes had left his own theory indeterminate and it was only with the advent of the Hicks-Hansen IS-LM system that a determinate solution for the rate of interest could be obtained" (Fletcher 1987: 120).

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