A Simplified, Graphical Exposition of Keynes's Argument on Pages 179-181 of the General Theory About the Equation Missing from the Neoclassical Theory of the Rate of Interest
26 Pages Posted: 4 Mar 2018
Date Written: February 22, 2018
Keynes provided a technical analysis on pages 179-181 of the General Theory that identified two separate rates of interest, r1 and r2, each different rate of interest associated with a different Demand for Investment and Supply of Savings Intersection. Each combination would provide a different, downward sloping IS curve in (r,Y) space. Keynes pointed out that it was impossible to identify the equilibrium, market clearing rate of interest because there was no LP(LM) curve derived from the Liquidity Preference Function, Demand for Money and Supply of Money. Keynes’s LP equation is the equation that Keynes identified as the missing equation that is necessary in order to decide whether the correct rate is r1 or r2. Keynes then stated the following: “But the above diagram does not contain enough data to tell us what its new value will be; and, therefore, not knowing which is the appropriate Y-curve, we do not know at what point the new investment demand-schedule will cut it. If, however, we introduce the state of liquidity-preference and the quantity of money and these between them tell us that the rate of interest is r2, then the whole position becomes determinate. For the Y-curve which intersects X 2X2’ at the point vertically above r2, namely, the curve Y2, will be the appropriate curve.”
Keynes’s upward sloping LP(LM) curve would cut the IS curve associated with r 2 from below. The result is a determinant rate of interest in Keynes’s (r.Y space).
The failure of economists to carefully analyze Keynes’s analysis on pages 179-181 of the General Theory accounts for the misbelief that Keynes’s theory of the rate of interest was a purely monetary theory of the rate of interest, although Keynes made it very clear to Hawtrey in correspondence in early 1936 that his theory of the rate of interest was NOT a purely monetary one.
Keywords: IS-LM, IS-LP(LM), Reddaway, Champernowne, Keynes, chapter 21, chapter 15, Keynes's views of math
JEL Classification: B10, B12, B14, B16, B20, B22
Suggested Citation: Suggested Citation