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A SUGGESTED INTERPRETATION1
By J. R. HICKS
I
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
1 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.
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-
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:
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 fundamental equations,
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
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
(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 equations.
(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.
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 goods.
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-
4 This can be readily seen if we consider the equations
J. B. HICKS 153
Consequently we have for the General Theory
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.
154 ECONOMETRICA
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,
pp. 201-202.
J. R. HICKS 155
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 of Depression.
6 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.
156 ECONOMETRICA
IV
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.
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
8 Since 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 is fulfilled.
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
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.
