John Hicks Keynes Versus The Classics

John Richard Hicks, Keynes Versus The Classics

In his second review of the General Theory (1937) Hicks com­plained that Keynes, in making his break with the Classics, had not set out a recognisable classical theory. Hicks then proceeds to remedy this defect by setting out a fairer representation of the Classical model in a form in which it can be more effectively contrasted with that of Keynes. Thus he sets out three equations for each model - representing the goods market, the investment sector and the money market - and then performed a comparison. His basic approach was to integrate these three equations into two curves-his famous SI/LL curves (now generally referred to as IS/LM).

In contrast to the elaborate four quadrant derivation of these curves which has become popular in the text books, Hicks's derivation can be paraphrased quite simply as follows: The money market equation M = L(Y, r) gives us a relation between income (Y) and the interest rate (r). This can be drawn out as a curve (LM) which will slope upwards since an increase in income tends to raise the demand for money and an increase in the interest rate tends to lower it. The other two equations:

/ = /(r)
I(r) = S(Y)

These relate investment (/) to savings (S) and give us another relation between income and interest. The first equation de­termines the value of investment at any given rate of interest and the second equation tells what level of income will be necessary to make savings equal to that value of investment. A curve IS can therefore be drawn showing the relation between Y and r which must be maintained in order to make saving equal to investment.

However the LM curve is likely to have a peculiar shape (see Figure 2). In the first place there will be a limit to how far the interest rate can fall (ensuring a horizontal section to the curve - the liquidity trap). Secondly there will be a maximum to the level of income that a given money supply can finance (giving rise to a vertical section).

Figure 2

The novelty of the IS/LM framework is that income and the rate of interest are determined simultaneously at point E. Thus, Hicks concludes that the quantity theory had tried to determine Y without r and therefore 'has to give place to a theory recognising a higher degree of interdependence' and accordingly Keynes's real innovation was this explicit recognition of interdependence in the goods, money and labour markets. However, Hicks was not at all convinced that Keynes's model (based on liquidity preference) was saying something completely different from the classical model (based on loanable funds)-except in the extreme situation of the liquidity trap. For example, in Keynes's theory an increase in the inducement to invest is supposed to increase Y (and employment) via the multiplier while in the classical loanable funds theory an increase in investment raises r. But Hicks points out (in his reviews of 1936 and 1937) that both approaches are only analysing the short-run impact effects and that when the whole process is traced through the result in each model is an increase in both Y and r. In Keynes's model although Y increases initially, there may eventu­ally be an increase in r because the demand for money will rise with the higher level of income. Similarly, in the classical model, although r increases initially, there may eventually be an increase in Y because velocity will rise with the higher rate of interest. Both of these forces are incorporated in the IS/LM model so that an increase in investment shifts the IS curve to the right and thereby raises both Y and r- outside the 'trap'.

This analysis highlights again Hick's obvious enthusiasm for general equilibrium solutions to even macroeconomic problems —especially where partial equilibrium'theory gives rise to spurious results. In this way Hicks demostrated the redundant nature of the liquidity preference versus loanable funds debate on the determination of the rate of interest. Using a general equilibrium approach he was able to show that the two theories are complementary rather than competitive because whether we choose to ignore the bond market (loanable funds) as Keynes did or the money market (liquidity preference) as did the Classics is simply a question of theoretical perspective; but the same results obtain in the end.

Having invented the IS/LM apparatus Hicks then notes 'It does not appear that we have exhausted the uses of that apparatus so let us conclude by giving it a little run on its own'. It is little exaggeration to say that the whole of macroeconomics in the 1950s and 1960s consisted in giving this apparatus some further 'little runs on its own'. Its impact on macro textbooks alone hardly needs elaboration. However, Hicks was more cautious-'it re­mains a terribly rough and ready affair. In particular, the concept of income is worked monstrously hard; most of our curves are not really determinate unless something is said about the distribution of income . . . and all sorts of questions about the timing of the processes under consideration [have been neglected]' (1937).

Despite these reservations, much of the monetarist versus Keynesian debate of the last twenty years has taken place within this framework and tremendously important policy conclusions have been based upon it. In this respect it is important to note that for purposes of economic analysis or policy discussions Hicks has never been too enamoured of the IS/LM model. Indeed he has used it only for purposes of exegesis and it was in this context that Keynes had originally approved of it: for example, referring to the 1937 article Keynes wrote to Hicks, 'I found it very interesting and have next to nothing to say by way of criticism'. Thus Hicks feels justified in claiming that 'Keynes accepted the IS/LM diagram as a fair statement of the nucleus of his position. That in any case was what it was meant to be-a means of demonstrating the nature of the difference between Keynes and his predecessors - not a statement of what I believed myself. It is much less a statement of my own view than the "Simplifying" article by which I continue to stand' (1977, pp. 144-7). We illustrate some of Hicks's recent contributions to monetary theory below; we turn now to Hicks's contribution to general equilibrium analysis.