MR. KEYNES AND THE "CLASSICS";
A SUGGESTED INTERPRETATION1
By J. R. HICKS
IT WILL BE ADMITTED by the least charitable reader that
the entertainment value of Mr. Keynes' General Theory of Employment is
considerably enhanced by its satiric aspect. But it is also clear that
many readers have been left very bewildered by this Dunciad. Even if they
are convinced by Mr. Keynes' arguments and humbly acknowledge themselves
to have been "classical economists" in the past, they find it hard to remember
that they believed in their unregenerate days the things Mr. Keynes says
they believed. And there are no doubt others who find their historic doubts
a stumbling block, which prevents them from getting as much illumination
from the positive theory as they might otherwise have got.
One of the main reasons for this situation is undoubtedly
to be found in the fact that Mr. Keynes takes as typical of "Classical
economics" the later writings of Professor Pigou, particularly The Theory
of Unemployment. Now The Theory of Unemployment is a fairly
new book, and an exceedingly difficult book; so that it is safe to say
that it has not yet made much impression on the ordinary teaching of economics.
To most people its doctrines seem quite as strange and novel as the doctrines
of Mr. Keynes himself; so that to be told that he has believed these things
himself leaves the ordinary economist quite bewildered.
For example. Professor Pigou's theory runs, to a
quite amazing extent, in real terms. Not only is his theory a theory of
real wages and unemployment; but numbers of problems which anyone else
would have preferred to investigate in money terms are investigated by
Professor Pigou in terms of "wage-goods." The ordinary classical economist
has no part in this tour de force.
But if, on behalf of the ordinary classical economist,
we declare that he would have preferred to investigate many of those problems
in money terms, Mr. Keynes will reply that there is no classical theory
of money wages and employment. It is quite true that such a theory cannot
easily be found in the textbooks. But this is only because most of the
textbooks were written at a time when general changes in money wages in
a closed system did not present an important problem. There can be little
doubt that most economists have thought that they had
Based on a paper which was read at the Oxford meeting of the Econometric
Society (September, 1936) and which called forth an interesting discussion.
It has been modified subsequently, partly in the light of that discussion,
and partly as a result of further discussion in Cambridge.
a pretty fair idea of what the relation between money wages and employment
In these circumstances, it seems worth while to
try to construct a typical "classical" theory, built on an earlier and
cruder model than Professor Pigou's. If we can construct such a theory,
and show that it does give results which have in fact been commonly taken
for granted, but which do not agree with Mr. Keynes' conclusions, then
we shall at last have a satisfactory basis of comparison. We may hope to
be able to isolate Mr. Keynes' innovations, and so to discover what are
the real issues in dispute.
Since our purpose is comparison, I shall try to
set out my typical classical theory in a form similar to that in which
Mr. Keynes sets out his own theory; and I shall leave out of account all
secondary complications which do not bear closely upon this special question
in hand. Thus I assume that I am dealing with a short period in which the
quantity of physical equipment of all kinds available can be taken as fixed.
I assume homogeneous labour. I assume further that depreciation can be
neglected, so that the output of investment goods corresponds to new investment.
This is a dangerous simplification, but the important issues raised by
Mr. Keynes in his chapter on user cost are irrelevant for our purposes.
Let us begin by assuming that w, the rate
of money wages per head, can be taken as given.
Let x, y, be the outputs of investment goods
and consumption goods respectively, and Nx, Ny, be the numbers of
men employed in producing them. Since the amount of physical equipment
specialised to each industry is given, x = fx(Nx) and y = fy
(Ny), where fx, fy, are given functions.
Let M be the given quantity of money.
It is desired to determine Nx and Ny.
First, the price-level of investment goods = their
marginal cost = w (dNx /dx). And the price-level of consumption
goods = their marginal cost = w(dNy/dy).
Income earned in investment trades (value of investment,
or simply Investment) = wx(dNx/dx). Call this Ix.
Income earned in consumption trades = wy(dNy/dy).
Total Income = wx (dNx/dx)+ wy (dNy/dy).
Call this I.
Ix is therefore a given function of Nx, I
of Nx and Ny. Once I and Ix are determined,
Nx and Ny can be determined.
Now let us assume the "Cambridge Quantity equation"-that
there is some definite relation between Income and the demand for money.
Then, approximately, and apart from the fact that the demand for money
may depend not only upon total Income, but also upon its dis-
J. R. HICKS 149
tribution between people with relatively large and relatively small demands
for balances, we can write
M = kl.
As soon as k is given, total Income is therefore determined.
In order to determine Ix, we need two equations.
One tells us that the amount of investment (looked at as demand for capital)
depends upon the rate of interest:
I = C(i).
This is what becomes the marginal-efficiency-of-capital schedule in Mr.
Further, Investment = Saving. And saving depends
upon the rate of interest and, if you like, Income. .'. Ix = S(i, I).
(Since, however, Income is already determined, we do not need to bother
about inserting Income here unless we choose.)
Taking them as a system, however, we have three
M = kl, Ix = C(i), Ix = S (i, I),
to determine three unknowns, I, Ix, i. As we have found earlier,
Nx and Ny can be determined from I and Ix.
Total employment, Nx + Ny, is therefore determined.
Let us consider some properties of this system.
It follows directly from the first equation that as soon as k and
M are given, I is completely determined; that is to say,
total income depends directly upon the quantity of money. Total employment,
however, is not necessarily determined at once from income, since it will
usually depend to some extent upon the proportion of income saved, and
thus upon the way production is divided between investment and consumption-goods
trades. (If it so happened that the elasticities of supply were the same
in each of these trades, then a shifting of demand between them would produce
compensating movements in Nx and Ny, and consequently no
change in total employment.)
An increase in the inducement to invest (i. e.,
a rightward movement of the schedule of the marginal efficiency of capital,
which we have written as C(i)) will tend to raise the rate of interest,
and so to affect saving. If the amount of saving rises, the amount of investment
will rise too; labour will be employed more in the investment trades, less
in the consumption trades; this will increase total employment if the elasticity
of supply in the investment trades is greater than that in the consumption-goods
trades-diminish it if vice versa.
An increase in the supply of money will necessarily
raise total income, for people will increase their spending and lending
until incomes have risen sufficiently to restore k to its former level.
The rise in income
will tend to increase employment, both in making consumption goods and
in making investment goods. The total effect on employment depends upon
the ratio between the expansions of these industries; and that depends
upon the proportion of their increased incomes which people desire to save,
which also governs the rate of interest.
So far we have assumed the rate of money wages to
be given; but so long as we assume that k is independent of the level of
wages, there is no difficulty about this problem either. A rise in the
rate of money wages will necessarily diminish employment and raise real
wages. For an unchanged money income cannot continue to buy an unchanged
quantity of goods at a higher price-level; and, unless the price-level
rises, the prices of goods will not cover their marginal costs. There must
therefore be a fall in employment; as employment falls, marginal costs
in terms of labour will diminish and therefore real wages rise. (Since
a change in money wages is always accompanied by a change in real wages
in the same direction, if not in the same proportion, no harm will be done,
and some advantage will perhaps be secured, if one prefers to work in terms
of real wages. Naturally most "classical economists" have taken this line.)
I think it will be agreed that we have here a quite
reasonably consistent theory, and a theory which is also consistent with
the pronouncements of a recognizable group of economists. Admittedly it
follows from this theory that you may be able to increase employment by
direct inflation; but whether or not you decide to favour that policy still
depends upon your judgment about the probable reaction on wages, and also-in
a national area-upon your views about the international standard.
Historically, this theory descends from Ricardo,
though it is not actually Ricardian; it is probably more or less the theory
that was held by Marshall. But with Marshall it was already beginning to
be qualified in important ways; his successors have qualified it still
further. What Mr. Keynes has done is to lay enormous emphasis on the qualifications,
so that they almost blot out the original theory. Let us follow out this
process of development.
When a theory like the "classical" theory we have just
described is applied to the analysis of industrial fluctuations, it gets
into difficulties in several ways. It is evident that total money income
experiences great variations in the course of a trade cycle, and the classical
theory can only explain these by variations in M or in k, or, as a third
and last alternative, by changes in distribution.
(1) Variation in M is simplest and most obvious,
and has been relied
J. R. HICKS 151
on to a large extent. But the variations in M that are traceable
during a trade cycle are variations that take place through the banks-they
are variations in bank loans; if we are to rely on them it is urgently
necessary for us to explain the connection between the supply of bank money
and the rate of interest. This can be done roughly by thinking of banks
as persons who are strongly inclined to pass on money by lending rather
than spending it. Their action therefore tends at first to lower interest
rates, and only afterwards, when the money passes into the hands of spenders,
to raise prices and incomes. "The new currency, or the increase of currency,
goes, not to private persons, but to the banking centers; and therefore,
it increases the willingness of lenders to lend in the first instance,
and lowers the rate of discount. But it afterwards raises prices; and therefore
it tends to increase discount."2 This is superficially
satisfactory; but if we endeavoured to give a more precise account of this
process we should soon get into difficulties. What determines the amount
of money needed to produce a given fall in the rate of interest? What determines
the length of time far which the low rate will last? These are not easy
questions to answer.
(2) In so far as we rely upon changes in k, we can
also do well enough up to a point. Changes in k can be related to changes
in confidence, and it is realistic to hold that the rising prices of a
boom occur because optimism encourages a reduction in balances; the falling
prices of a slump because pessimism and uncertainty dictate an increase.
But as soon as we take this step it becomes natural to ask whether k has
not abdicated its status as an independent variable, and has not become
liable to be influenced by others among the variables in our fundamental
(3) This last consideration is powerfully supported
by another, of more purely theoretical character. On grounds of pure value
theory, it is evident that the direct sacrifice made by a person who holds
a stock of money is a sacrifice of interest; and it is hard to believe
that the marginal principle does not operate at all in this field. As Lavington
put it: "The quantity of resources which (an individual) holds in the form
of money will be such that the unit of money which is just and only just
worth while holding in this form yields him a return of convenience and
security equal to the yield of satisfaction derived from the marginal unit
spent on consumables, and equal also to the net rate of interest."3
The demand for money depends upon the rate of interest! The stage is set
for Mr. Keynes.
2 Marshall, Money,
Credit, and Commerce, p. 257.
3 Lavington, English
Capital Market, 1921, p. 30. See also Pigou, "The Exchange-value of Legal-tender
Money," in Essays in Applied Economics, 1922, pp. 179-181.
As against the three equations at the classical theory,
M=kl, Ix=C(i), Ix =S (i, I)
Mr. Keynes begins with three equations,
M=L(i), Ix=C(i), Ix =S (I).
These differ from the classical equations in two ways. On the one the demand
for money is conceived as depending upon the rate of interest (Liquidity
Preference). On the other hand, any possible influence of the rate of interest
on the amount saved out of a given income is neglected. Although it means
that the third equation becomes the multiplier equation, which performs
such queer tricks, nevertheless this second amendment is a mere simplification,
and ultimately insignificant.4 It is the liquidity
preference doctrine which is vital.
For it is now the rate of interest, not income,
which is determined I by the quantity of money. The rate of interest set
against the schedule of the marginal efficiency of capital determines the
value of investment; that determines income by the multiplier. Then the
volume of employment (at given wage-rates) is determined by the value of
investment and of income which is not saved but spent upon consumption
It is this system of equations which yields the
startling conclusion, that an increase in the inducement to invest, or
in the propensity to consume, will not tend to raise the rate of interest,
but only to increase I employment. In spite of this, however, and in spite
of the fact that quite a large part of the argument runs in terms of this
system, and this system alone, it is not the General Theory. We may call
it, if we like, Mr. Keynes' special theory. The General Theory is something
appreciably more orthodox.
Like Lavington and Professor Pigou, Mr. Keynes does
not in the end believe that the demand for money can be determined by one
variable alone-not even the rate of interest. He lays more stress on it
than they did, but neither for him nor for them can it be the only variable
to be considered. The dependence of the demand for money on interest does
not, in the end, do more than qualify the old de-
This can be readily seen if we consider the equations
M = kl, I = C (i), Ix = S(I),
which embody Mr. Keynes' second amendment without his first.
The third equation is already the multiplier equation, but the multiplier
is shorn of his wings. For since I still depends only on M, Ix now depends
only on M, and it is impossible to increase investment without increasing
the willingness to save or the quantity of money. The system thus generated
is therefore identical with that which, a few years ago, used to be called
the "Treasury View." But Liquidity Preference transports us from the "Treasury
View" to the "General Theory of Employment."
J. B. HICKS 153
pendence on income. However much stress we lay upon the "speculative motive,"
the "transactions" motive must always come is as well.
Consequently we have for the General Theory
M = L (I, i), Ix = C (i), Ix = S (I).
With this revision, Mr. Keynes takes a big step back
to Marshallian orthodoxy, and his theory becomes hard to distinguish from
the revised and qualified Marshallian theories, which, as we have seen,
are not new. Is there really any difference between them, or is the whole
thing a sham fight? Let us have recourse to a diagram (Figure 1).
Against a given quantity of money, the first equation,
M = L (I, i), gives us a relation between Income (I) and
the rate of interest (i). This can be drawn out as a curve (LL)
which will slope upwards, since an increase in income tends to raise the
demand for money, and an increase in the rate of interest tends to lower
it. Further, the second two equations taken together give us another relation
between Income and interest. (The marginal-efficiency-of-capital schedule
determines the value of investment at any given rate of interest, and the
multiplier tells us what level of income will be necessary to make savings
equal to that value of investment.)
The curve IS can therefore be drawn showing
the relation between Income and interest which must be maintained in order
to make saving equal to investment. Income and the rate of interest are
now determined together at P, the point of intersection of the curves
LL and IS. They are determined together; just as price and
output are determined together in the modern theory of demand and supply.
Indeed, Mr. Keynes' innovation is closely parallel, in this respect, to
the innovation of the marginalists.
The quantity theory tries to determine income without interest, just as
the labour theory of value tried to determine price without output; each
has to give place to a theory recognising a higher degree of interdependence.
But if this is the real "General Theory," how does
Mr. Keynes come to make his remarks about an increase in the inducement
to invest not raising the rate of interest? It would appear from our diagram
that a rise in the marginal-efficiency-of-capital schedule must raise the
curve IS; and, therefore, although it will raise Income and employment,
it will also raise the rate of interest.
This brings us to what, from many points of view,
is the most important thing in Mr. Keynes' book. It is not only possible
to show that a given supply of money determines a certain relation between
Income and interest (which we have expressed by the curve LL); it
is also possible to say something about the shape of the curve. It will
probably tend to be nearly horizontal on the left, and nearly vertical
on the right. This is because there is (1) some minimum below which the
rate of interest is unlikely to go, and (though Mr. Keynes does not stress
this) there is (2) a maximum to the level of income which can possibly
be financed with a given amount of money. If we like we can think of the
curve as approaching these limits asymptotically (Figure 2).
Therefore, if the curve IS lies well to the
right (either because of a strong inducement to invest or a strong propensity
to consume), P will lie upon that part of the curve which is decidedly
upward sloping, and the classical theory will be a good approximation,
needing no more than the qualification which it has in fact received at
the hands of the later Marshallians. An increase in the inducement to invest
will raise the rate of interest, as in the classical theory, but it will
also have some subsidiary effect in raising income, and therefore employment
as well. (Mr. Keynes in 1936 is not the first Cambridge economist to have
a temperate faith in Public Works.) But if the point P lies to the
left of the LL curve, then the special form of Mr. Keynes' theory
becomes valid. A rise in the schedule of the marginal efficiency of capital
only increases employment, and does not raise the rate of interest at all.
We are completely out of touch with the classical world.
The demonstration of this minimum is thus of central
importance. It is so important that I shall venture to paraphrase the proof,
setting it out in a rather different way from that adopted by Mr. Keynes.5
If the costs of holding money can be neglected, it will always be
5 Keynes, General Theory,
J. R. HICKS 155
profitable to hold money rather than lend it out, if the rate of interest
is not greater than zero. Consequently the rate of interest must always
be positive. In an extreme case, the shortest short-term rate may perhaps
be nearly zero. But if so, the long-term rate must lie above it, for the
long rate has to allow for the risk that the short rate may rise during
the currency of the loan, and it should be observed that the short rate
can only rise, it cannot fall.6 This does not
only mean that the long rate must be a sort of average of the probable
short rates over its duration, and that this average must lie above the
current short rate. There is also the more important risk to be considered,
that the lender on long term may desire to have cash before the agreed
date of repayment, and then, if the short rate has risen meanwhile, he
may be involved in a substantial capital loss. It is this last risk which
provides Mr. Keynes' "speculative motive" and which ensures that the rate
for loans of indefinite duration (which he always has in mind as the rate
of interest) cannot fall very near zero.7
It should be observed that this minimum to the rate
of interest applies not only to one curve LL (drawn to correspond
to a particular quantity of money) but to any such curve. If the supply
of money is increased, the curve LL moves to the right (as the dotted
curve in Figure 2), but the horizontal parts of the curve are almost the
same. Therefore, again, it is this doldrum to the left of the diagram which
upsets the classical theory. If IS lies to the right, then we can
indeed increase employment by increasing the quantity of money; but if
IS lies to the left, we cannot do so; merely monetary means will
not force down the rate of interest any further.
So the General Theory of Employment is the Economics
It is just conceivable that people might become so used to the idea of
very low short rates that they would not be much impressed by this risk;
but it is very unlikely. For the short rate may rise, either because trade
improves, and income expands; or because trade gets worse, and the desire
for liquidity increases. I doubt whether a monetary system so elastic as
to rule out both of these possibilities is really thinkable.
7 Nevertheless something
more than the "speculative motive" is needed to account for the system
of interest rates. The shortest of all short rates must equal the relative
valuation, at the margin, of money and such a bill; and the bill stands
at a discount mainly because of the "convenience and security" of holding
money-the inconvenience which may possibly be caused by not having cash
immediately available. It is the chance that you may want to discount the
bill which matters, not the chance that you will then have to discount
it on unfavourable terms. The "precautionary motive," not the "speculative
motive, is here dominant. But the prospective terms of rediscounting are
vital, when it comes to the difference between short and long rates.
In order to elucidate the relation between Mr. Keynes
and the "Classics," we have invented a little apparatus. 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.
M = L (I, i), Ix = C (I, i), Ix = S(I, i)?
Once we raise the question of Income in the second equation,
it is clear that it has a very good claim to be inserted. Mr. Keynes is
in fact only enabled to leave it out at all plausibly by his device of
measuring everything in "wage-units," which means that he allows for changes
in the marginal-efficiency-of-capital schedule when there is a change in
the level of money wages, but that other changes in Income are deemed not
to affect the curve, or at least not in the same immediate manner. But
why draw this distinction? Surely there is every reason to suppose that
an increase in the demand for consumers' goods, arising from an increase
in employment, will often directly stimulate an increase in investment,
at least as soon as an expectation develops that the increased demand will
continue. If this is so, we ought to include I in the second equation,
though it must be confessed that the effect of I on the marginal
efficiency of capital will be fitful and irregular.
With that apparatus at our disposal, we are no longer
obliged to make certain simplifications which Mr. Keynes makes in his exposition.
We can reinsert the missing i in the third equation, and allow for any
possible effect of the rate of interest upon saving; and, what is much
more important, we can call in question the sole dependence of investment
upon the rate of interest, which looks rather suspicious in the second
equation. Mathematical elegance would suggest that we ought to have I
and i in all three equations, if the theory is to be really General. Why
not have them there like this:
The Generalized General Theory can then be set out
in this way. Assume first of all a given total money Income. Draw a curve
CC showing the marginal efficiency of capital (in money terms) at that
given Income; a curve SS showing the supply curve of saving at that
given Income (Figure 3). Their intersection will determine the rate of
interest which makes savings equal to investment at that level of income.
This we may call the "investment rate."
If Income rises, the curve SS will move to
the right; probably CC will move to the right too. If SS
moves more than CC, the investment rate of interest will fall; if
CC more than SS, it will rise. (How much it rises and falls,
however, depends upon the elasticities of the CC and SS curves.)
The IS curve (drawn on a separate diagram)
now shows the relation
J. R. HICKS 157
between Income and the corresponding investment rate of interest. It has
to be confronted (as in our earlier constructions) with an LL curve
showing the relation between Income and the ''money" rate of interest;
only we can now generalise our LL curve a little. Instead of assuming,
as before, that the supply of money is given, we can assume that there
is a given monetary system-that up to a point, but only up to a point,
monetary authorities will prefer to create new money rather than allow
interest rates to rise. Such a generalised LL curve will then slope
upwards only gradually-the elasticity of the curve depending on the elasticity
of the monetary system (in the ordinary monetary sense). As before, Income
and interest are determined where the IS and LL curves intersect-where
the investment rate of interest equals the money rate. Any change in the
inducement to invest or the propensity to consume will shift the IS
curve; any change in liquidity preference or monetary policy will shift
the LL curve. If, as the result of such a change, the investment
rate is raised above the money rate. Income will tend to rise; in the opposite
case, Income will tend to fall; the extent to which Income rises or falls
depends on the elasticities of the curves.8
C (I,i) = S(I, i),
The savings investment market will not be stable unless
dS/di+ (- dC/di) is positive. I think we may assume that this condition
If dS/di is positive, dC/di negative,
dS/dI and dC/dI positive (the most probable state of affairs), we can say
that the IS curve will be more elastic, the
When generalised in this way, Mr. Keynes' theory begins
to look very like Wicksell's; this is of course hardly surprising.9
There is indeed one special case where it fits Wicksell's construction
absolutely. If there is "full employment" in the sense that any rise in
Income immediately calls forth a rise in money wage rates; then it is possible
that the CC and SS curves may be moved to the right to exactly
the same extent, so that IS is horizontal. (I say possible, because
it is not unlikely, in fact, that the rise in the wage level may create
a presumption that wages will rise again later on; if so, CC will
probably be shifted more than SS, so that IS will be upward
sloping.) However that may be, if IS is horizontal, we do have a
perfectly Wicksellian construction;10 the
investment rate becomes Wicksell's natural rate, for in this case it may
be thought of as determined by real causes; if there is a perfectly elastic
monetary system, and the money rate is fixed below the natural rate, there
is cumulative inflation; cumulative deflation if it is fixed above.
This, however, is now seen to be only one special
case; we can use our construction to harbour much wider possibilities.
If there is a great deal of unemployment, it is very likely that dC/dI
will be quite small; in that case IS can be relied upon to slope
downwards. This is the sort of Slump Economics with which Mr. Keynes is
largely concerned. But one cannot escape the impression that there may
be other conditions when expectations are tinder, when a slight inflationary
tendency lights them up very easily. Then dC/dI may be large and
an increase in Income tend to raise the investment rate of interest. In
these circumstances, the situation is unstable at any given money rate;
it is only an imperfectly elastic monetary system-a rising LL curve-
that can prevent the situation getting out of hand altogether.
These, then, are a few of the things we can get
out of our skeleton apparatus. But even if it may claim to be a slight
extension of Mr. Keynes' similar skeleton, it remains a terribly rough
and ready sort of 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 as well as its magnitude.
Indeed, what they express is something like a relation between the price-system
and the system of interest rates; and you cannot get that into a curve.
Further, all sorts of questions about depreciation have been neglected;
and all sorts of questions about the timing of the processes under consideration.
greater the elasticities of the CC and SS curves, and
the larger is dC/dl relatively to dS/dl. When dC/dI > dS/dl, the IS curve
is upward sloping.
9 Cf. Keynes,
General Theory, p. 242.
10 Cf. Myrdal, "Gleichgewichtsbegriff,"
in Beitrage zur Geldtheorie, ed. Hayek.
J. R. HICKS 159
The General Theory of Employment is a useful book; but
it is neither he beginning nor the end of Dynamic Economics.