On J. M. Keynes’s Application of His IS-LM (LP) Model in His Reply to Viner in His Article the General Theory of Employment in February, 1937: Keynes Emphasized the Horizontal, Completely Elastic Range of the LM (LP) Curve

Abstract

Keynes used his IS-LM(LP) model to reply to Viner’s claims that he had drastically overestimated the role that liquidity preference played in the macro economy in explaining the events of 1929-1933 in the world economy. Viner claimed that liquidity preference could only play a very minor role in impacting the economy as a whole. This amounts to the claim that financial manipulation and stock market speculation can play a role that is, at best, of very minor significance. Viner’s assessment is identical to his claim made in his Journal of Political Economy paper in 1927 that Adam Smith’s criticisms of projectors, imprudent risk takers and prodigals, as illustrated by the very negative impact of the British East India Company on Scotland’s economy in the 18th century, could, at best, play only a very minor role. Viner’s answer was identical to that of Jeremy Bentham, who claimed that Smith’s projectors, imprudent risk takers and prodigals were really just inventors and innovating entrepreneurs. The government authorities should never interfere in the markets for any reason, should “be quite”, and “stay out of the sunshine” of the private sector economy. Of course, this Benthamite Utilitarian creed, taught at the University of Chicago’s Economics department in the 1920’s, is why American government authorities did nothing in the years between 1929-1933 to stop the Great Depression. They had been taught Laissez Faire from University of Chicago economists. Everything was supposed to improve by itself on its own. The economy was guaranteed to recover only if government did nothing. Viner’s argument, then, is that it is impossible to have a liquidity trap (Keynes’s absolute liquidity preference).Keynes challenged Viner’s argument using IS-LM(LP)analysis in his reply in February, 1937. Keynes emphasized in his reply to Viner in February,1937, that he was very concerned about the highly elastic range of the LM(LP) curve. Keynes combined this with an emphasis on the highly inelastic range of the IS curve, as Keynes’s IS curve is the opposite of Viner’s ,since, given Viner’s highly inelastic LM(LP) curve, he needs an IS curve that is highly elastic in order to get “…a small decline in money-income would lead, as stated above, to a large fall in the rate of interest.” Keynes thus is very concerned with the parameters of the IS-LM(LP) curves, although he clearly views the major problem with the IS curve as being its instability and shift ability, due to the impacts of confidence on mec calculations involving expectations. Keynes not only provided the first IS-LM model, but also explicitly considered the elasticity of the curves as well both in the GT in 1936 and in the GTE in 1937. Paul Krugman’s twenty five years of emphasis on the necessity of basing macroeconomics on IS-LM(LP) is correct. A minor point is that it is primarily Keynes, and not Hicks, who was responsible for the explicit development and application of the IS-LM(LP) model. Keynes would, of course, also point out the necessity of grounding IS-LM(LP) on a foundation involving some type of D-Z model.