Review of John Hicks’ Article ‘a Suggested Interpretation of Keynes’

We aim to examine the British economist Sir John Hick’s article ‘Mr Keynes and the “classics”; A suggested interpretation (April 1937)’ in which Hicks seeks to devise a simpler more cruder ‘classical’ model of the imperial, however complicated work of Professor Pigou’s ‘The theory of unemployment’ that will rightfully disagree with Mr Keynes’s mystifying but accepted proposal in his ‘General theory of unemployment.’ We seek to explore the proposed model by Hicks with the support of mathematics, economic behaviour and theory from his own independent views as well established economists.

To the amusement of the reader Hicks initially portrays Keynes’ work as ‘satiric’ and ‘bewildered,’ this is a clear indication that Hicks is not very fond of the book The General Theory of Employment, however he acknowledges many of Keynes’ views are widely accepted by classical economists. This is true as many Classical views are outdated, as when in his book Keynes attacks the views of Classical Economists as ‘its teaching is misleading and disastrous if we attempt to apply it to the facts of experience.’ Sir Hicks goes on to applaud Pigou’s “The Theory of Unemployment” however recognises it is “an exceedingly difficult book,” which is why it is not accepted by modern economists. Hicks differentiates Pigou’s work from Classical Economists view as being more ambitious; Pigou’s work is described as being a ‘tour de force’ as he talks in real terms in his writings, whereas other economists talk in “money terms.”

Hick’s believes that it is hard to compare Keynes’ work with Pigou’s as Classical economists would have liked to ‘investigate many of those problems in money terms’ so as to draw comparisons, however Hicks state that although Keynes says ‘there is no classical theory of money wages and employment,’ he was wrong as in those times ‘general changes in money wages in a closed system did not present an important problem.’ By this he means that Pre 1930’s labour markets were a lot more flexible. It was only in the early 1900’s that there were liberal reforms that led to the formation of the Trade Boards Act of 1909, which created a minimum wage by law – making it a penal offence to hire labour at a lower rate than that fixed.

Hicks’ attempt to devise a more simplistic “classical” theory, results in a mathematical construction of a typical classical theory, in order to produce a model which would constitute for a cruder ‘satisfactory basis for comparison.’ The basis for our belief in Hicks’ actions in simplifying Pigou’s model is Hicks’ recognition that Pigou’s theory has no support from the ordinary more simplistic classical models, ‘the ordinary classical economist has no part in this tour de force.’ Further it can be made evident that Hicks’ view on the Keynesian apparatus, as being a competent apparatus, is a widely accepted view as stated by Friedman – “We all use the Keynesian language and apparatus” and moreover Hicks’ proposal to use Keynesian model is consistent with economists in this time period. However, both Hicks and Friedman disagree with the final conclusions of Keynesian theory. Hicks states ‘which do not agree with Mr Keynes’ conclusion,’ where Friedman supports “none of us any longer accepts the initial Keynesian conclusions.”

This supplements Hicks’ reasons for establishing a new model based on the Keynesian theory, which adheres to some classical ideals. Prior to making this model Hicks makes a number of assumptions; first being ‘dealing with a short period of time in which the quantity of physical equipment of all kinds is taken as fixed.’ Hicks assumes ‘homogenous labour’ and ‘further that depreciation can be neglected, so that the output of investment goods corresponds to new investment.’ These assumptions as a base of construction for his model will indefinitely lead to less realistic results and accuracy than the complicated work of Pigou, as Pigou looked into real wages, in contrast to money wages. The assumption to neglect depreciation is ‘dangerous’ as described by Sir Hicks himself.

The danger occurs as most investment goods may experience depreciation of assets and capital, which will in turn affect the cost of production resulting in firms having less profit. This could be a big factor in the number of people a firm can employ, consequently affecting the unemployment rate. This shows the danger can be off vast effect. However, the assumption of such danger is of necessity to devise a simple model. Taking into account appreciation of assets and goods is of too much complication and will be almost impossible to calculate and formulate with consistency and reliability. A model characteristic Hicks seeks to avoid. The rational and fair views of Hicks’ new approach can be further fortified where he refers to “Classical economics” and “Keynesian” in the same sentence, ‘thus I assume that I am dealing with a short period in which the quantity of physical equipment of all kinds available can be taken as fixed. Hicks generates ‘three fundamental equations’ denoting: w = Rate of money wages/person

There are only 2 industries; Investment goods and consumption goods x = Output of investment goods (PQx)
y = Output of consumption goods (PQy)
There are 2 Factors of production in short run (Labour and Capital) as Land and Enterprise are fixed, so our output function including labour and capital is shown by: x=fx(Nx,C)
y=fy(Ny,C)
Nx = Number of people employed in producing x
Ny = Number of people employed in producing y
However we negate Capital as we are considering it fixed in the short run (from Hicks’ assumptions) leaving us with the functions: x=fx(Nx)
y=fy(Ny)
f has diminishing marginal productivity (following neoclassical theory), so as N increases the amount of output (x or y) increases at a decreasing rate M = Given quantity of money
We need M to find Nx and Ny
Hicks denotes price level of investment goods as:
(Px) = marginal cost of x = wdNxdx = wage • Marginal Product of Labour (investment) Where;
dNx,ydx,y = marginal product of labour (labour is only variable input) It is the change in labour input (dNx,y) for every change in output (dx,y). Hicks denotes price level of consumption goods as:

(Py) = marginal cost of y = wdNydy= wage • Marginal Product of Labour (consumption) As we know: Income = Value of output = Price • Quantity
Ix = income earned in investment trades
Iy = income earned in consumption trades
To work out total income we find the sum of price multiplied by quantity of both industries: Ix=PxQx=wdNxdxx
Iy=PyQy=wdNydyy
Here is our final equation for income:
I=Ix+Iy=wdNxdxx+ wdNydyy

To formulate our equations we know that money demands (M) = velocity of money (k) x income (I) M=kI
The amount of money invested is the demand for Capital, which is dependent on interest rates. Ix=C(i)
Income is equal to (Consumption + Investment).
Savings is 1- Consumption
So Savings = Investment
S=I
So, the amount of money invested is savings which is determined by interest rate and level of investment Ix=S(i,I)
So, we have our three equations:
M=kI Ix=C(i) Ix=Si,I
Our equation M=kI is taken form the “Cambridge quantity equation”. As k=1V and I=PY we can re-write this as:
MV=PY
From this equation we can derive the level of Inflation given the change in money supply and level of GDP growth. We have built a model to demonstrate this. We can hold the velocity of money as constant due to the “Quantity Theory” Assume:

ΔM=6%
ΔGDP=2%
To work out the inflation rate we find the change in Price level (P) We take the logarithm of the Cambridge equation:

logM+logV=logP+logY

We then differentiate by t so as to find the rate:

d logMdt+d logVdt=d logPdt+d logYdt

We know that velocity is constant:
d logVdt=0

Therefore we can calculate the inflation rate (%∆ P overtime)

d logMdt-d logYdt=d logPdt
6%-2%=4%
Inflation rate is therefore 4% if money supply increases by 6% and GDP growth is 2%

Leading on from Hicks’ construction he makes three considerations as ‘total money income experiences great variations in the course of a trade cycle’ in which the classical theory can only explain with changes in distribution by variations M (Quantity of money) or in k (time before money is spent). The first consideration Hicks addresses is the variation in M that occurs at the bank. The focus of Hicks being the connection between the supply of bank money and the rate of interest is admittedly ‘superficially satisfactory.’ Hicks being aware of the criticisms, leads away from full accuracy and precision as ‘What determines the amount of money needed to produce a given fall in the rate of interest?’, ‘What determines the length of time for which the low rate will last.’ These are not questions that can be easily answered nor those he attempt to. Second consideration relies on changes in k in which Hicks recognises a predicament with the “independent variable” k, as the fluctuations in the variable would be directly related to consumer confidence which is plausible as ‘rising prices of a boom occur because optimism encourages a reduction in balances’ and vice versa in a slump.

This leads Hicks to the question whether k can fulfil its role as an independent variable in the equation. Although this point is of realism; to have different denotations of k to mirror the levels of consumer confidence within a trading cycle would lead to more complication than the original problem in which it’s best to have k as independent to lead Hicks away from the complication he frowns upon from Pigou. Third is based on pure value theory derived from Lavington. “Lavington focused on the formation of rational behaviour under uncertainty. In the Marshallian tradition, this was an asset (money and security) demand theory, which consequently led to Keynes’ liquidity preference. 1921,” – Lavington argued that the individual demand for money was influenced not only by an individual’s income but also by the rate of interest and the state of his/her expectations.

In Hicks’ comparison of the classical equation and the Keynes equation he focuses heavily on the criticism of Keynes’ work as he crudely describes Keynes’ equation as ‘queer tricks’ due to Keynes neglecting the influence of the rate of interest on the amount saved out of a given income. From Keynes ‘starling’ proposal Hicks concludes that an increase in the inducement to invest, or in the propensity to consume, will not tend to raise the rate of interest, but only to increase employment. Here Hicks is typically pessimistic of the work of Keynes as he scorns his work further by proposing his book should be renamed ‘the special theory’ rather than general theory as its work is more unorthodox than in general. As Keynes goes further into his work he revises his equation, in which Hicks doesn’t stop belittling his work by stating, ‘Mr Keynes takes a big step back to the Marshallian orthodoxy’ declaring the revised work of Keynes is not new and ‘closely parallel, in this respect to the innovation of the Marginalists.’ This indicates that the work of Keynes is an imitation and what initially should have been a comparison of the two equations became a constant thump to one, Mr Keynes.

No brakes are applied to the constant attacks thrown by Sir Hicks at Keynes’ book as he scrutinizes Keynes’ remarks that ‘an increase in the inducement to invest not raising the rate of interest’. Incomes and employment will increase the rate of interest when the IS curve is raised due to a raise in the marginal efficiency of capital; the area Hicks deems to be of most importance in Mr. Keynes’ Book. When looking at this we see that the expected rate of return on investment would bring about a shift to the right for the IS curve, relating to expectation in future yields and the actual price of the capital good. Hicks progresses to the dynamics of the LL curve, ‘nearly horizontal on the left, and nearly vertical on the right.’ Relating to near enough two extremist views upon where an economy’s equilibrium could lie on the LL curve. It would be only feasible to discuss both areas of the curve and explain why they are of such gradient. Hicks suggests this is down to the ‘minimum below which the rate of interest is unlikely to go.’ proposing a certain level at which interest rates cannot go below until it would be improper for lenders to lend (refer to figure 1) Fig [ 1 ]

This is a liquidity trap within a depression; we find the supply of money increasing and the rate of interest so low that the monetary policy wouldn’t be effective (classical economist beliefs). The short-term interest rates would be low but never zero as ‘the rate of interest must always be positive.’ People assume that in the short term interest rates are low, but their expectations of the rate of interest will rise in the long term. When in such situation individuals would find it appropriate to save and await the low rate of interest. We can see that the horizontal line represents Keynes theory of how employment increases, however the monetary policy would be ineffective due to the low interest rate and therefore the economy would remain in stagnation.

‘Rise in the schedule of the marginal efficiency of capital only increases employment, and does not raise the rate of interest at all.’ Indicating ‘if point P lies to the left of the LL curve…. Keynes is valid’, therefore we assume that Keynes’ interpretation of the LL Curve is where Hicks regards his work as acceptable to an extent, but only to a world where we are ‘completely out of touch with the classical.’ Furthermore, Keynes’ use of the long rate as “the” rate of interest in the General Theory did not mean a representative rate but a particular rate, which raised Hicks’ (1974, pp. 32-33) criticism. This follows our point of how Hicks disregards Keynes’ assumption as his flaw was that of, it did not represent the real world, he followed one direction that lead to doubts, it was unreliable to Hicks as he did not believe consumers had “no alternative but to hold money.”

Secondly, we look at the other side of the LL curve spectrum of which takes the classical view that ‘nearly vertical on the right’ Hicks informs us that this is because of ‘a maximum to the level of income which can possibly be financed with a given amount of money.’ We see that from an increase in the IS curve would bring about a rise in investment and the rate of interest, thus increasing employment and income, Hicks is walking down the path that all classical theorist took. The economy is operating at a near full capacity in relation to employment, as total income cannot be increased due to the inelasticity of the line. (Refer to figure 1) This leads us to the belief that if we were to be at a point on the left of the LL curve we would find ourselves at an on-going battle of depression, as injections into the circular flow would be halted due to the amount of saving. But with an increase in the supply of money, we can always see investments increasing. Yes interest rates would increase, but our economy would see growth yearly as employment and both incomes increased making us at a better-off position than before. (Refer to figure 2)

Sir Hicks having critiqued his own assumptions is now continuous to conclude his apparatus in the fourth section. Hicks reinserts i being interest in the third equation and allows for any possible effect of the rate of interest on saving. He then debates whether Keynes was right to ignore income in his second equation although being allowed to due to his equation assuming measurement in ‘wage units.’ However, although Keynes ignored I, Hicks agrees I to be a creditable variable in the second equation as it allows for increase in a demand for consumers goods, thus increasing employment, therefore increasing investment. Hicks does however highlight that the effect on I on marginal efficiency of capital will be fitful and irregular, defeating the purpose of creating a crude model. Hicks then re-establishes his theory using his and Keynes IS LM model which incorporates all facets of his functions and variables for his apparatus. He highlights how the monetary system is still assumed, which means an effect on interest rates thus effecting investment which is a component of AD, effecting income assuming a certain multiplier.

Hicks highlights however that the slope of the IS curve is determined by the elasticity of the monetary system meaning the change in the liquidity preference will shift the LL curve – which may raise the investment rate above the money rate, therefore, income will tend to rise; in the reverse scenario income may fall, the extent relative to the elasticity. Hicks states when comparing Keynes, that when generalised in this was Keynesian fits the “wicksellian construction,” but goes on to outline Wicksells model as “one special case” as it refers investment to become Wicksells natural rate. Hicks concludes his review by accepting the variable of I to have been exhausted in his experimentation of his crude model. Hicks acknowledges that income is fundamental to his model and not all underlying determinants of income such as the ‘relation between price system and the system of interest rates’ can be shown together on a graph.

Hicks further acknowledges the earlier dismissal of depreciation which will dampen the complexity of establishing the investment level, thus latter effecting income then interest rate v income. ‘The General Theory of Employment is a useful book; but it is neither the beginning nor the end of dynamic economics,’ concludes by underlining Keynes book developing our understanding, however it is not a definitive guide as dynamic economics provides a constantly revolving economic system in terms of behaviour of markets, business and general economy so trying to create a crude model opens the new apparatus up for much scrutiny as many assumptions that are assumed or ignored are highly volatile and could act to the models detriment.

We commend Hicks on his fantastic article. We feel he has given a good interpretation of both Classical and Keynesian schools of thought. In summary Hicks says that if the “IS curve lies well to the right” the classical view that monetary policy is the only policy for increasing incomes and employment. This is because it will shift the LM curve and lower the rate of interest and also increase the amount of income. Classical economists believe that using fiscal policy would only push the rate of interest higher and not increase incomes much at all. However if our economies IS curve lies to the left then credibility starts building for Keynes. This would make Keynes’s book “The General Theory of Employment, Interest and Money” as being the “economics of depression”; where the LM curve is horizontal. Keynes says that to increase incomes and employment Fiscal Policy should be the main tool by lowering taxes and increasing government expenditure to increase consumption and stimulate Aggregate demand. This will increase incomes and employment and will not have so much inflationary pressures as there are many unemployed resources making Aggregate supply very elastic. As we know total Incomes in a closed economy are a sum of Consumption expenditure, Investment expenditure and Government expenditure, shown: Y=C+I+G

Keynes gives us the consumption function:
C=a+b(Y-T) a>0, 0<b<1
And we can put together an equation for working out total tax: T=d+tY d>0, 0<t<1
Where:
Y=National Income
C=Planned Consumption Expenditure
I=Investment Expenditure
G=Governemnt Expenditure
T=Taxes

Endogenous Variables: Y, C, T
Exogenous Variables: I, G
a=autonomous consumption
b=marginal propensity to consume
d=non-income tax
t=income tax
These equations show equilibrium of an economy.
To solve to find out what Y, C and T are we re-arrange formula: Y-C+0T=I+G
-bY+C+bT=a
-tY+0C+T=d

These systems of equations can be written in Matrix form
1-10-b1b-tY01•YCT=I+Gad
Using Cramer rule to solve:
D=11b01–1-bb-t1+0
D=11+1-b+bt
D=1-b1-t
Ddoesnt equal 0 because b is between 0 and 1 and t is between 0 and 1 Solving to find Y:
DY=I+G-10a1bd01
DY=a-bd+I+G
Y=DYD
Y=a-bd+I+G1-b1-t

Solving to find C:
DC=1I+G0-bab-td1
DC=a+bI+Gb-bd-btI-Gbt
DC=a-bd+b1-tI+G
C=DCD
C=a-bd+b1-tI+G1-b1-t
Solving to find T:
DT=1-1I+G-b1a-t0d
DT=d+tI+Gt-bd+at
DT=d-bd+at+tI+G
T=DTD
T=d-bd+at+tI+G1-b1-t

Given the two different methods for increasing Incomes and employment, which both aim on moving us closer to economic prosperity, Hicks doesn’t deal with the concept of Income distribution. If incomes rise it does not necessarily mean that employment will rise, as if income distribution worsens then we could be experiencing high levels of unemployment alongside rising total incomes.

References:

[1] JM Keynes (1936). The General Theory of Employment, Interest, and Money.
London: Palgrave Macmillan. p11.

[2] Sidney Webb. (1912). The Economic Theory of a Legal Minimum Wage. The Journal of Political Economy. 20 (10), 973.

[3]Lavington 1921, pp. 82–3; 1925/26, p. http://www.econ.ryukoku.ac.jp/activity/images/activity03.pdf

[4] Lavington 1921, pp. 82–3; 1925/26, p. http://www.econ.ryukoku.ac.jp/activity/images/activity03.pdf
[5] Mauro Boianovsky, (2003) http://e-groups.unb.br/face/eco/cpe/TD/282Mar03MBoianovsky.pdf

[6] Mauro Boianov-sky, (2003) http://e-groups.unb.br/face/eco/cpe/TD/282Mar03MBoianovsky.pdf

[ 1 ]. JM Keynes (1936). The General Theory of Employment, Interest, and Money. London: Palgrave Macmillan. p11. [ 2 ]. Sidney Webb. (1912). The Economic Theory of a Legal Minimum Wage. The Journal of Political Economy. 20 (10), 973. [ 3 ]. Lavington 1921, pp. 82–3; 1925/26, p. http://www.econ.ryukoku.ac.jp/activity/images/activity03.pdf [ 4 ]. Lavington 1921, pp. 82–3; 1925/26, p. http://www.econ.ryukoku.ac.jp/activity/images/activity03.pdf [ 5 ]. http://www.george.irvin.com/MASD1/session4.htm

[ 6 ]. http://krugman.blogs.nytimes.com/2011/10/09/is-lmentary/ [ 7 ]. Mauro Boianovsky, (2003) http://e-groups.unb.br/face/eco/cpe/TD/282Mar03MBoianovsky.pdf [ 8 ]. Mauro Boianovsky, (2003) http://e-groups.unb.br/face/eco/cpe/TD/282Mar03MBoianovsky.pdf