In October 1936, John Hicks sent Keynes a letter in which he raised the issue of liquidity preference and interest rate theories and also sent Keynes a draft of his famous paper “Mr. Keynes and the ‘Classics’; A Suggested Interpretation” (Econometrica 5.2 [1937]: 147–159).
Keynes replied to Hicks on 31 March, 1937 in a letter that is sometimes taken to show that Keynes strongly approved of IS-LM (the letter can be found in Keynes 1973: 79–81).
Unfortunately, I have not had the time to chase up and read the full copy of Keynes’ letter, but some have actually argued that Keynes’ reaction to Hicks’ paper was only “lukewarm” (Kriesler and Nevile, “IS-LM and Macroeconomics after Keynes,” p. 4).
At any rate, Joan Robinson notes that Keynes did object to the model in his letter to Hicks:
“Whenever equilibrium theory is breached, economists rush like bees whose comb has been broken to patch up the damage. J. R. Hicks was one of the first, with his IS-LM, to try to reduce the General Theory to a system of equilibrium. This had a wide success and has distorted teaching for many generations of students. Hicks used to be fond of quoting a letter from Keynes which, because of its friendly tone, seemed to approve of IS-LM, but it contained a clear objection to a system that leaves out expectations of the future from the inducement to invest.” (Robinson 1978: 13).So Keynes did have reservations about the model’s ability to incorporate expectations, and also about loanable funds theory (Tily 2007: 207–208).
Moreover, Keynes and Hicks had further correspondence. In a later letter, Hicks affirmed that he was thinking of interest as determined by a type of loanable funds theory, or “by saving and investment” (Keynes 1973: 82).
Keynes replied in a short letter on 11 April, 1937 rejecting loanable funds:
Keynes to Hicks, 11 April, 1937The “short article” Keynes was writing was “Alternative Theories of the Rate of Interest” (The Economic Journal 47.186 [1937]: 241–252), in which Keynes numbered Hicks with Bertil Ohlin and Dennis Robertson as a supporter of loanable-funds, a theory which Keynes himself rejected (Keynes 1937: 241–243; Tily 2007: 209).
“Dear Hicks,
I do not really understand how you mean interest to be determined by saving and investment under II, near the bottom of your second page. However, I am trying to bring the whole thing to a head by a short article I shall write for the next Journal commenting on Ohlin’s exposition of the Swedish theory of interest regarded as determined by the demand and supply for loans, which is being printed in the same issue. I am there accusing you of agreeing with the Swedes in this matter. If this is a calumny, and your theory is really quite different, forgive me.
Yours sincerely,
J.M.K.”
(Keynes 1973: 83).
By implication, Keynes must have thought that Hicks held a theory of the interest rate that was wrong (Tily 2007: 209).
If IS-LM relies on a loanable funds model, and Keynes rejected loanable funds, then it is difficult to see how Keynes could have supported IS-LM, if he had been consistent.
And Hicks did continue to adhere to a modified form of loanable funds, and was even taken to task for it by others sympathetic to the General Theory like Hugh Townshend (1937) (King 2002: 22).
One can perhaps conclude that far too much has been read into the short and private letter Keynes wrote to Hicks, where Keynes may well have been being polite and encouraging to Hicks, and at the same time did not want to pick a fight with someone who was sympathetic to the General Theory.
BIBLIOGRAPHY
Hicks, J. R. 1936. “Keynes’ Theory of Employment,” The Economic Journal 46.182: 238–253.
Keynes, John Maynard. 1937. “Alternative Theories of the Rate of Interest,” The Economic Journal 47.186: 241–252.
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.”
http://www.asb.unsw.edu.au/schools/economics/Documents/P.%20Kriesler%20and%20J.%20Nevile%20-%20IS-LM%20in%20Macroeconomics%20After%20Keynes.pdf
Robinson, Joan. 1978. “Keynes and Ricardo,” Journal of Post Keynesian Economics 1.1: 12–18.
Tily, Geoff. 2007. Keynes’s General Theory, The Rate of Interest and Keynesian Economics: Keynes Betrayed. Palgrave Macmillan, New York, N.Y.
Townshend, Hugh. 1937. “Liquidity-Premium and the Theory of Value,” The Economic Journal 47.185: 157–169.
“Myrdalian ex ante language would have saved the General Theory from describing the flow of investment and the flow of saving as identically, tautologically equal, and within the same discourse, treating their equality as a condition which may, or not, be fulfilled.”
ReplyDeleteG.L.S Shackle,
(1989) “What did the General Theory do?”, in J. Pheby (ed), New Directions in Post-keynesian Economics, Aldershot: Edward Elgar
To paraphrase Richard Hackam, if Keynes accepted IS-LM, then it must then appear that the Post Keynesian interpretation of Keynes is seriously in error on a number of major issues.
ReplyDeleteNone of this is to suggest that the Post Keynesians have not made valuable contributions, both in their analysis of some of the fundamental questions of macroeconomics and in reviving interest in Keynes's own writings. But such contributions might better, perhaps, have been put forward and discussed on the own intrinsic merits rather than as an interpretation of 'what Keynes really meant'.
Anonymous,
DeleteDid you even read this post, and the evidence that Keynes had reservations about IS-LM?
Keynes was forced to accept the IS-LM model because he made money demand a function of income in the General Theory (p.199).
ReplyDeleteKeynes's liquidity preference theory of the interest rate is indeterminate. The interest rate cannot be determined solely by the supply and demand for money if money demand is a function of income.
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: 141).
If money demand is a function of income, then changes in investment and saving MUST affect the interest rate:
"An increase in thrift will, through the multiplier process, lead to less real income being generated by a given level of investment.... Less income is generated through the multiplier process as a result of the increase in thrift; less income requires a lower transactionary demand for money" (Presley: 190).
An increase in saving will lower income. Lower income means lower money demand. A decrease in the demand for money lowers the interest rate in Keynes's liquidity preference theory.
Keynes did not realize that his liquidity preference theory was indeterminate until after the publication of the General Theory. Hicks, Hansen, Meade, Harrod, and Lange made Keynes realize that the liquidity preference theory was indeterminate. They showed Keynes how his theory could be saved. The result was the IS-LM model.
Keynes made consumption AND money demand a function of income, so he had to accept the IS-LM model:
"Keynes's "reaction to IS/LM curves was somewhat surprising; he was evidently over-awed by Hick's constructive interpretation of his theory ... Keynes offered no fundamental criticism of Hick's important article (Presely: p. 191).
Post Keynesians have failed to understand and recognize Keynes's dilemma. Post Keynesians are still stuck in this dilemma. Post Keynesians have three options:
1. Post Keynesians can argue consumption is not a function of income; or
2. Post Keynesians can argue money demand is not a function of income; or
3. Post Keynesians can accept the IS-LM model just like Keynes did.
"If IS-LM relies on a loanable funds model, and Keynes rejected loanable funds, then it is difficult to see how Keynes could have supported IS-LM, if he had been consistent"
ReplyDeleteThe problem with this argument is sequence and timing.
Maybe Keynes believed in 1937 that the interest rate was a purely monetary phenomenon and completely unaffected by saving and investment. However, by 1938 Keynes recognized that saving and investment did influence the interest rate:
"in his eagerness to show that the rate of interest was determined by the activities of wealth-holders in choosing between holding of bonds or money, Keynes forgot the influence of the level of income in the (transactions) demand for money. Because each increase in the level of income would increase the demand for money, the total demand for money and, therefore, the rate of interest could not be known until the level of income was known. Therefore, 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)
By 1938, Keynes had recanted. He acknowledged that saving and investment must influence the interest rate:
“Keynes failed in his attempt to fashion a ‘purely monetary’ theory of interest; that is, that Keynes had attempted to break with classical and neo-classical tradition by excluding real forces of productivity and thrift from having any significant part in the determination of the rate of interest. Subsequently, and under the influence of Robertson’s argument, he had been forced to recant” (Fletcher 1987: 124)
“In the General Theory Keynes sought to weaken the forces of productivity and thrift acting upon the rate of interest to the benefit of liquidity preference and the supply of money … Keynes position changed substantially in the period after 1936…. Keynes was no longer able to ignore the role of productivity and thrift in the interest rate” (Presley: 209).
We know that Keynes recanted by 1938 because he wrote in the Economic Journal: "The analysis which I gave in my General Theory of Employment is the same as the ‘general theory’ explained by Dr. Lange".
Keynes is referring to Lange's 1938 presentation of the IS-LM model called "The Rate of Interest and the Optimum Propensity to Consume".
The argument that Keynes rejected IS-LM because he rejected the loanable funds theory is untenable. Keynes recanted and abandoned his pure liquidity preference theory by 1938 (at the latest). This argument does not prove that Keynes rejected IS-LM.
"If IS-LM relies on a loanable funds model, and Keynes rejected loanable funds, then it is difficult to see how Keynes could have supported IS-LM, if he had been consistent"
ReplyDeleteIS-LM combines the capital market (aka market for loans or however you wanna call it) with Keynes' liquidity preferences aka the money market. Keynes has never rejected "loanable funds", liquidity preferences alone determine the demand for money but you need the IS part to connect it with investment.
Instead of doing Keynesian exegesis people should study some basic economics and understand basic stuff like "which 3 markets are actually modelled by IS-LM?".
He never had any pure liquidity preference theory to recant. Liquidity preference is part of a generalization of neoclassical microeconomics.
DeleteIn particular, liquidity preference is not the holding of money for transaction motive. Hence, the classic derivation of IS-LM is incompatible with Keynes's ideas.
Keynes's model can be used to derive IS-LM under some special assumptions, by keeping the other parameters fixed with usual ceteris paribus reasoning.
" Hicks used to be fond of quoting a letter from Keynes which, because of its friendly tone, seemed to approve of IS-LM, but it contained a clear objection to a system that leaves out expectations of the future from the inducement to invest.”
ReplyDelete' . . . in his letter of 31 March 1937, commenting on a draft of Hicks' 1937 paper, Keynes wrote: “I found it very interesting and really have next to nothing to say by way of criticism.”'
http://www.econ.ucla.edu/workingpapers/wp537.pdf
"One can perhaps conclude that far too much has been read into the short and private letter Keynes wrote to Hicks, where Keynes may well have been being polite and encouraging to Hicks, and at the same time did not want to pick a fight with someone who was sympathetic to the General Theory."
Was this 'picking a fight'?
In reply to a letter to Harrod: Keynes said: “instructive and illuminated” But, “you don't mention effective demand.” P3
http://www.econ.ucla.edu/workingpapers/wp537.pdf