Investopedia Needs to Heavily Revise Its ‘IS-LM Model’ Paper
21 Pages Posted: 26 Aug 2020
Date Written: July 20, 2020
The prevalent belief among economists that Hicks invented and developed the IS-LM model in 1937 ,which Keynes then accepted provisionally when shown the paper by Hicks, is a myth, much like the myth that R. Kahn invented the multiplier. Hick’s IS-LM model paper on the General Theory, published in the April,1937 issue of Econometrica, is based on pp.199-205 of Keynes’s General Theory plus Hicks’s unattributed use of materials that were based on Reddaway’s and Champernowne’s June, 1936 reviews of the General Theory in the Economic Record and Review of Economic Studies, respectively, but which Hicks deliberately did not cite. It is easy to compare Hicks’s June,1936 review paper, published in the Economic Journal in June,1936, which had no IS-LM model in it, with both the Reddaway and Champernowne papers, also available in June,1936,which have explicit IS-LM models specified in them.There is no mention of any IS-LM model in Hicks’s June 1936 paper in the Economic Journal at all. That Reddaway and Champernowne should have IS-LM models in their reviews should not be surprising because Keynes created,developed ,improved and taught his original IS-LM model to his students at Cambridge in the 1933- 1935 time period. Reddaway and Champernowne were in attendance at those 1933-35 lectures.
The only conclusion possible is that Hicks plagiarized the work of both Reddaway and Champernowne.
Keynes’s first IS-LM model appears in Keynes’s lectures of December 4th ,1933(See Dimand ,1989;2003;2007). However, before publishing the General Theory ,Keynes decided to split his IS-LM model of 1933-35, that he had taught to Reddaway and Champernowne, into two parts, the D-Z Aggregate Demand and Supply model of chapter 20 that dealt with uncertainty,expectations, the theory of the firm ,production functions, marginal optimality conditions and the labor market, and the published IS-LM model in chapter 21 in Part IV on pp.298-299 of the General Theory. Keynes followed these pages with a five page discussion (pp.300-304) of the possible deficiencies in the model that might arise because some variables were left out of the model that would complicate the application of the model. Keynes followed this with a mathematical version integrating the liquidity preference function (LM) into his chapter 20 analysis which is specified on pp.304-306 of the General Theory.
Hicks’s 1937 version is inferior to both the Reddaway and Champernowne 1936 versions. Champernowne incorporated in his June,1936, analysis a role for uncertainty, expectations, the theory of the firm, production functions, marginal optimality conditions and the labor market. Reddaway did not explicitly incorporate uncertainty, expectations, the theory of the firm ,production functions,marginal optimality conditions and the labor market.Hicks realized that his own presentation, involving a comparison -contrast between Keynes and the neoclassical models, first done by Champernowne, could not deal with expectations and uncertainty because his neoclassical theory did not deal with these issues.Therefore, Hicks decided to remove the analysis from his paper of uncertainty, expectations, the theory of the firm, production functions, marginal optimality conditions and the labor market.
Modigliani’s 1944 paper on IS-LM in Econometrica can be seen as an attempt to integrate what was already present in chapter 20 of the General Theory and Champernowne’s paper into Hicks’s deficient model. Unfortunately, Modigliani made four errors which vitiate the analysis in his paper. The four errors made by Modigliani are:
1) to substitute risk for uncertainty,
2)substitute perfect competition for pure competition,
3)substitute a single ,macroscopic equilibrium for Keynes’s macroscopic, multiple equilibria,and
4)to present the microeconomic optimality conditions as actual results instead of expected results,where the actual real wage equals the marginal productivity of labor instead of Keynes’s expected real wage equals the marginal productivity of labor.
Keynes’s Aggregate Supply Curve(ASC ) was reduced by Modigliani to a single macro equilibrium position instead of being a set of macro multiple equilibria.
Keynes’s General Theory can thus be studied using either Champernowne’s single model of IS-LM or by Keynes’s two model construction of D-Z plus IS-LM.Hick’s model can thus be seen to be equal to Keynes’s model of IS-LM plus D-Z minus the D-Z model. Hick’s IS-LM model is Champernowne’s model minus an analysis of uncertainty, expectations, the theory of the firm, production functions, marginal optimality conditions and the labor market.
Keynes pointed out to both Harrod and Hicks in correspondence in 1937 that their IS -LM variations of his IS-LM model ignored his theory of effective demand construction, which is the D-Z model.However, this went over their heads because they were not able to follow the mathematical analysis in chapter 20, which is the foundation for the analysis in chapter 21 of the General Theory.
We can now see that the fundamental problem for the last 84 years is that the economics profession is unable to deal with chapter 20 on the theory of effective demand. Instead, Keynes’s initial, introductory, simple beginning outline in chapter 3 of the General Theory, which has no model, is substituted for chapter 20, where the model is specified and developed mathematically. Chapter 21 makes no sense unless the reader has understood chapter 20, which is also required to understand the appendix to chapter 19.
The reason this happened is that Keynes’s critique of Pigou’s mathematical modeling in his 1933 The theory of Unemployment on pp.275-276 and on pp.297-298 of the General Theory is interpreted wrongly as a critique of all formal economics mathematical modeling. This was the Joan Robinson gambit. She was an extraordinary mathematical illiterate economist. Robinson had absolutely no idea about what Keynes was doing mathematically. She succeeded in convincing the economics profession that it could skip chapters 20 and 21 because Keynes was a Marshallian who would burn the mathematics because he did not believe in published formal analysis. Robinson’s gambit worked extremely well, so well in fact that there is no economist in the 20th or 21st century who had any idea that Keynes’s IS-LM model was sitting right under their noses on pp. 298-299 of the General Theory.
Keywords: J M Keynes Theory of the Rate of Interest Liquidity Preference Mathematics Mathematical Illiterate
JEL Classification: B10, B12, B14, B16, B18, B20, B22
Suggested Citation: Suggested Citation