# Keynes on Uncertainty and His IS-LM Model in the 1937 Quarterly Journal of Economics Reply: There Never Was Any Conflict between Keynes's Definition of Uncertainty and Keynes's IS-LM Model

33 Pages Posted: 26 Jun 2017 Last revised: 17 Feb 2018

Date Written: June 25, 2017

### Abstract

J M Keynes used his 1937 Quarterly Journal of Economics reply to emphasize (a) the importance of his concept of uncertainty, which he had defined as an inverse function of the weight of the evidence in chapter twelve on p. 148 of the General Theory, and (b) the fact that the neoclassical theory of the rate of interest was incomplete. Two curves are needed. Neoclassicals only provided one. Keynes did not use the references to the A Treatise on Probability he had used in the General Theory because Keynes’s article represents a brief summary and reply that is based on the extensive analysis in the General Theory.

Keynes’s final summary on pp. 222-223 of his 1937 Quarterly Journal of Economics reply is very direct and straightforward. It has two parts. The first part concentrates on the importance of uncertainty in decision making as it is connected to m e c calculations concerning expected, future returns to durable, physical, capital goods subject to technological change and advance in the long run. The neglect of this issue by neoclassical theory, based on Bentham’s known probabilities and known outcomes approach in his utility maximization model, leads to an incomplete theory of the rate of interest which requires Keynes’s Liquidity Preference equation in order to arrive at a determinate rate of interest. The second part of Keynes’s final summary deals with the importance of the Multiplier and the positive relationship that exists between consumption and investment goods. Economists have taken some of his comments from his reply out of context by deliberately only citing those portions of the quotation that fit their own preconceived, a priori biases while ignoring Keynes’s analysis in other sections of the paper that totally refute their claims.

The misinterpretations of Minsky, Shackle, Robinson and Davidson are examined. First, the belief that Keynes changed his definition of uncertainty in this article, from being a range that could vary from little or mild uncertainty to moderate uncertainty to severe uncertainty to acute uncertainty to complete uncertainty (ignorance), to mean complete ignorance or irreducible uncertainty, an extreme outlier in Keynes’s theory in the A Treatise on Probability and General Theory, is false. Keynes continued to use the word “degrees” throughout this article. Second, Keynes used his summary in the Quarterly Journal of Economics to repeat the main points he had made on pp.180-184 and 199-202 of the General Theory about his liquidity preference equation being the missing equation that was required in order to have a determinate answer to what the rate of interest was if income could change. Neoclassical theory had no liquidity preference equation. Without the liquidity preference equation, there can be no determinate theory of the rate of interest in Income and interest rate space.

The major reason why Keynes’s GT can’t ever be accepted in the economics profession is that the economics profession, be it 1936 or 2016, accepts a theory of probability and decision making that Keynes explicitly rejected in the TP, GT and in the QJE. That theory is some kind of psychological or personalist version of the Bayesian, subjectivist theory of Ramsey, de Finetti, Savage, and Friedman. When Keynes was writing the TP, it was associated with Irving Fisher, Poincare, and Borel. This theory explicitly rejects the existence of uncertainty as defined by Keynes as a function of the weight of the evidence. Acceptance of the weight of the evidence distinction between strong and weak evidence directly leads to non additivity and non linearity as the general case. Non additivity requires interval valued probability. Non linearity leads directly to non linear probability preferences.This leads to the collapse of the standard subjectivist approach which requires the assumptions of additivity and linearity. This then leads to multiple equilibria in the goods market and permanent disequilibrium in the labor market. This permanent disequilibrium has absolutely nothing to do with sticky money wages.

Keynes finally decided to take Bentham on directly in the QJE article. He had tried to finesse this by attacking only Bentham’s students, primarily Say and Ricardo, in the GT. The QJE reply makes it clear that Keynes is directly rejecting Bentham’s entire apparatus of probability and decision making, which is impossible to apply if there is any degree of uncertainty.

“Modern” economists are, overwhelmingly, still Bentham’s students.

**Keywords:** Harrod, Hicks, Keynes, IS-LM, Liquidity preference, QJE 1937, chapter 15, pp.180-182 of GT

**JEL Classification:** B10, B12, B14, B16, B20, B22

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