Mr. Keynes and the "Classics"; A Suggested Interpretation

This paper, written within a year of the publication of Keynes’s General Theory, asks how much of Keynes’s theory is genuinely new by building a small formal model of the “classical” theory of income and employment to serve as a basis of comparison, then reconstructing Keynes’s own theory in the same terms. Hicks shows that the classical system – money demand proportional to income (the Cambridge equation), investment as a function of the interest rate, and saving determined jointly by income and the interest rate – differs from Keynes’s system essentially in one respect: Keynes makes the demand for money depend on the interest rate as well as income (liquidity preference), a change Hicks judges “vital,” whereas dropping the interest rate from the saving function is “a mere simplification … ultimately insignificant.” Reinstating income in the money-demand equation to get the full “General Theory” system, Hicks derives a diagram of two curves in income-interest-rate space – one from the money market, one from the goods market – whose intersection jointly determines income and the interest rate, the construction later known as the IS-LM model. Because Hicks argues there is a floor below which the interest rate cannot fall, the money-market curve is nearly flat at low levels of income; when the goods-market curve intersects it on that flat stretch, expanding the desire to invest raises income and employment but leaves the interest rate unmoved, which is Keynes’s “special theory” and, in Hicks’s words, makes “the General Theory of Employment … the Economics of Depression”; away from that stretch, the classical-style result – where more investment raises the interest rate too – reasserts itself. A final section generalizes the apparatus further, letting income affect investment and the interest rate affect saving, and shows how the resulting system connects to Wicksell’s natural rate of interest, while Hicks explicitly flags that the concept of aggregate “Income” is being asked to do more analytical work than it can fully bear.

J. R. Hicks | Macro Paper Warehouse

Mr. Keynes and the "Classics"; A Suggested Interpretation