History: John Maynard Keynes Getting One Very Wrong

Here it is plain to me that Keynes has simply not understood John Hicks–call this Keynes “Keynes the Pre-Hicksian”:

John Maynard Keynes (1937): The General Theory of Employment: “There are passages which suggest that Professor Viner is thinking too much…

…in the more familiar terms of the quantity of money actually hoarded,and that he overlooks the emphasis I seek to place on the rate of interest as being the inducement not to hoard. It is precisely because the facilities for hoarding are strictly limited that liquidity preference mainly operates by increasing the rate of interest. I cannot agree that “in modern monetary theory the propensity to hoard is generally dealt with, with results which in kind are substantially identical with Keynes’, as a factor operating to reduce the ‘velocity’ of money.” On the contrary, I am convinced that the monetary theorists who try to deal with it in this way are altogether on the wrong track.

Again, when Professor Viner points out that most people invest their savings at the best rate of interest they can get and asks for statistics to justify the importance I attach to liquidity-preference, he is over- looking the point that it is the marginal potential hoarder who has to be satisfied by the rate of interest, so as to bring the desire for actual hoards within the narrow limits of the cash available for hoarding. When, as happens in a crisis, liquidity-preferences are sharply raised, this shows itself not so much in increased hoards–for there is little, if any, more cash which is hoardable than there was before–as in a sharp rise in the rate of interest, i.e. securities fall in price until those, who would now like to get liquid if they could do so at the previous price, are persuaded to give up the idea as being no longer practicable on reasonable terms. A rise in the rate of interest is a means alternative to an increase of hoards for satisfying an increased liquidity-preference.

Nor is my argument affected by the admitted fact that different types of assets satisfy the desire for liquidity in different degrees. The mischief is done when the rate of interest corresponding to the degree of liquidity of a given asset leads to a market-capitalization of that asset which is less than its cost of production…

It seems very clear that this Keynes has not yet read–or has not understood–John Hicks (1937), “Mr. Keynes and the ‘Classics’: A Suggested Interpretation”.

Keynes thinks that money demand consists of three terms:

  • kPY, the amount of money needed to grease the amount PY of total nominal spending,
  • S, the liquidity-preference speculative demand for money, and
  • -jr, a term that depends on increases in the interest rate r curbing the speculative demand for money, and also inducing people to economize on their transactions balances.

For a given money supply, M, this gives us a money demand-money supply equation:

M = kPY + S – jr

Jacob Viner wants to take this equation and rewrite it in quantity-theory terms as an LM-curve relation:

kPY = M – S + jr

Y = [M – S + jr]/Pk

Y = (M/P)V, with V = [1-(S/M)-(jr/M)]/k

An increase in Keynes’s liquidity preference S is thus a reduction in the velocity of money V associated with any interest rate r. This is what Viner means when he writes that:

In modern monetary theory the propensity to hoard is generally dealt with, with results which in kind are substantially identical with Keynes’, as a factor operating to reduce the ‘velocity’ of money.

And he is correct.

Keynes says he disagrees. He claims that the key effect of a rise in liquidity preference is not to reduce the velocity of money–to produce “increased hoards”–but rather to raise the interest rate r. And working through the IS-curve relation:

Y = C + I
C = co + (cy)Y
I = io – (ir)r
Y = [co + io]/(1-cy) – [ir/((1-cy)]r

This rise in r reduces real spending Y.

Keynes is right when he says that an increase in liquidity preference S reduces Y working through the IS-curve relationship. But Keynes is wrong when he says that implies that Viner is wrong. Viner is right too. The LM-curve and the IS-curve relations jointly determine Y and r. You can use either. In fact, you have to use both in order to get an answer, even if you are not aware that you are using both. That is what Hicks made clear. But Keynes does not know it. And I see no signs that Viner knows it either.

November 10, 2015


Brad DeLong
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