What I am reading: Hicks Classic Paper

Mr. Keynes and the "Classics"; A Suggested Interpretation - J. R. Hicks (1937)

This is the paper that introduced the IS-LM apparatus as Hicks interpretation of Keynes General Theory.  Hicks is frequently criticized for abandoning Keynes focus on the financial market speculation as a driving force behind booms and busts but the revolutionary element of this paper is pretty apparent when you compare it to what else was going on at the time.  In this paper Hicks created the framework that macroeconomics would build around for the next 40 years.  He does this by constructing simple equilibrium models representing what the "Classicals" (read Pareto, Marshall, Pigou) had argued and what he interpreted Keynes to be saying (at least in part) in the General Theory.

Hicks assumes in both models an IS equation representing equilibrium in the market for loans i(r)=I = S(Y,r).  He then argues that the major difference between the Classicals and Keynes is in the specification of money demand.  The Classicals attribute money demand to a transactions motive as represented by the Cambridge equation M=k*Y while Keynes argues that money is held as an asset - in simplest form M=m(r).  Hicks extends this to the "General" theory M=m(r,Y) which is our modern LM equation.  Note that in the Classical model M -> Y without any involvement of r.  r and I are then determined by Y and the IS equilibrium.  In Keynes shocks to M are passed through to Y at least in part via M's impact on r.  Keynes simple case says M->r->Y and Keynes general case says M->(r,Y) two equations in two unknowns which must be solved simultaneously.

Finally Hicks asks how we are to reconcile this model with Keynes view that monetary policy was ineffective in escaping major downturns.  Hicks posits the liquidity trap - an L shaped LM curve with a horizontal portion on the left and a vertical portion on the right.  If the IS-LM equilibrium (r,Y) currently lies on the horizontal portion of the LM curve then manipulating the money supply shifts the LM right / left but leaves the (r,Y) equilibrium unchanged.  Fiscal policy however will shift the IS along the horizontal LM leading to a change in Y while leaving r unchanged.   If the current IS-LM equilibrium (r,Y) currently lies on the vertical portion of the LM curve then monetary policy will again be effective.

Next up Modigliani...