Correcting Modigliani's 1944 'Liquidity Preference and the Theory of Interest and Money': This Article Dealt with Hicks's Interpretation of Keynes, but not with Keynes's General Theory Model

21 Pages Posted: 30 Jun 2017

See all articles by Michael Emmett Brady

Michael Emmett Brady

California State University, Dominguez Hills

Date Written: June 29, 2017


F. Modigliani’s 1944 paper, “Liquidity Preference and the Theory of Interest and Money”, aimed at supplying the missing labor market and production function analysis in Hicks’s 1937 Econometrica paper. However, Modigliani ignored the fact that Keynes had already provided exactly that analysis in chapters 20 and 21 of the General Theory to support his own IS LM analysis from chapters 14, pp.180-182 and chapter 15 pp.199-202 and pp.208-209 of the General Theory.

F. Modigliani was an advocate of the personalist, psychological, Bayesian Subjectivist approach to Probability of Ramsey, de Finetti, Savage and Friedman. Modigliani was unable to deal with Keynes’s definition of uncertainty in the General Theory, which was that uncertainty was an inverse function of the weight of the evidence, which Keynes analyzed in chapters 6 and 26 of the A treatise on Probability. Uncertainty means that probability and risk estimates can’t be calculated in an accurate and reliable manner. This would mean that the confidence one has in one’s estimates is important. However, all Subjectivist Bayesians argue that there is no such thing as the confidence that a decision maker has in his probability estimates because the probability estimate is his degree of confidence. Therefore, there can be no such variable that measures the confidence that a decision maker has in the relative strength and/or weakness of the relevant evidence upon which the probabilities are being estimated. The state of confidence can’t be accepted as a variable that will be taken into account by a decision maker.

Therefore, liquidity preference must be a function of risk only. A probability distribution is assumed to be known for certain by all decision maker, so that the expected price level will be a precise, exact determinate number. All of these points were rejected by Keynes in the A treatise on Probability and General Theory. In fact, for Keynes the expected price level is imprecise or indeterminate. Therefore, the expected real wage is imprecise or indeterminate.

Modigliani’s subjectivist approach to probability results in Modigliani incorrectly specifying the demand for labor function in Keynes’s General Theory by ignoring Keynes’s definition in the General Theory that the demand for labor curve is a function of the expected real wage and not the actual real wage. The actual real wage, (w/p) can’t be specified precisely because workers and employers only know their nominal money wage, w, for certain. p is expected and can only be represented by an interval estimate form of probability. This will automatically lead to multiple equilibria, only one of which will be consistent with Modigliani’s one, unique, stable full employment equilibrium.

Modigliani also erred in explicitly assuming that the theory of the firm-industry used in the General Theory was the Theory of Perfect Competition, so that the expected price level, p, is known for certain based on the assumptions of perfect information and perfect prediction. In fact, Keynes used the theory of Pure Competition and expressly made it clear that there were a number of different expected price levels held with varying degrees of probability and definiteness on p.24 in footnote 3 of the General Theory. There was not only one expected value, as assumed by Modigliani.

None of Modigliani’s conclusions regarding liquidity preference hold in the Keynesian system analyzed by Keynes in chapters 13-15 and 19-21 of the GT based on uncertainty. Modigliani’s conclusions only hold in his redefined model where risk is substituted for uncertainty, perfect competition is substituted for pure competition, and a known, definite, precise real wage is substituted for Keynes’s expected, imprecise, indeterminate real wage.

Keywords: Harrod, Hicks, IS-LM, Liquidity preference, Modigliani, perfect competition versus pure competition

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

Suggested Citation

Brady, Michael Emmett, Correcting Modigliani's 1944 'Liquidity Preference and the Theory of Interest and Money': This Article Dealt with Hicks's Interpretation of Keynes, but not with Keynes's General Theory Model (June 29, 2017). Available at SSRN: or

Michael Emmett Brady (Contact Author)

California State University, Dominguez Hills ( email )

1000 E. Victoria Street, Carson, CA
Carson, CA 90747
United States

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