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 : 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 : 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).
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.
(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.
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.”
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.