Liquidity Preference and the Theory of Interest and Money

This 1944 Econometrica paper by Franco Modigliani sets out to reconcile the Keynesian and classical theories of interest and money by building three complete macrostatic systems of equations – a “Keynesian” system, a “crude classical” system built on the quantity theory, and a “generalized classical” system – that share identical saving, investment, and money-demand (liquidity-preference) relations and differ only in the equation describing the supply of labor: perfectly elastic at a fixed money wage up to full employment in the Keynesian case, versus a wage rate that adjusts to a market-clearing real wage in the classical cases. Working through the resulting model in Part I, using the LL curve (money-market equilibrium) and IS curve (goods-market equilibrium) apparatus built on Hicks’s earlier work, Modigliani argues that Keynesian underemployment equilibrium is in general due to rigid, institutionally fixed money wages rather than to liquidity preference as such, and that liquidity preference alone under fully flexible wages is sufficient to produce underemployment equilibrium only in a special limiting case – the “Keynesian case” – where the interest rate needed to restore full employment falls below the minimum rate at which the demand for money to hold becomes infinitely elastic. He similarly argues that liquidity preference is neither necessary nor sufficient to explain why the interest rate depends on the money supply; that dependence, too, is in general a consequence of wage rigidity rather than of liquidity preference itself. In Part II, Modigliani uses this framework critically: he argues that a shortfall of investment causes unemployment only in the Keynesian case rather than in general; that Oscar Lange’s charge of a logical contradiction in the classical dichotomy between money and real variables fails once the required homogeneity of expectations functions is properly specified; that A. P. Lerner’s claim that saving and investment play no role in determining the interest rate rests on mistaking a reduced-form relation, obtained only after solving the whole system, for a primitive demand-for-money schedule; and that J. R. Hicks’s attempt to explain the interest rate by the “imperfect moneyness” of securities and the cost of investing conflates a necessary condition for money to be held at all with an explanation of the level of the interest rate, which the paper instead locates in the propensities to save and invest under flexible wages, and in those propensities together with money supply and wage rigidity in the general case.

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.

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Liquidity Preference and the Theory of Interest and Money

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