The 'economics of depression' revisited: Hicks, Keynes, and the IS-LM model

The IS-LM model provided a formal structure for Hicks’s classic and controversial interpretation of Keynes’s General Theory.  This paper argues that Hicks was correct to make the liquidity function the centerpiece of the “Economics of Depression.” Furthermore, his particular interpretation of the Keynesian conditions for “absolute liquidity preference,” subsequently called a “liquidity trap,” is a reasonable interpretation of Keynes (1936).  The purpose of this paper is to suggest an alternative set of conditions inspired by Keynes (1937).  Ironically, once this overlooked special case is recognized, the IS-LM framework provides a simple, convenient, and surprisingly robust means of illustrating the Depression case of a more general theory of macroeconomic fluctuations.  The modified General Theory is one that includes “black swan” events and generalized policy ineffectiveness.

In the Hicksian liquidity trap, absolute liquidity preference occurs when the interest rate reaches an irreducible low and the demand for liquidity becomes highly elastic with respect to the interest rate.  An alternative interpretation starts with Keynes’s assertion that the “propensity to hoard” is linked with “opinions of the future yield of capital assets.” An alternative version of the liquidity trap (or liquidity sump) occurs when any increase in money income is simply hoarded.  Familiar “Keynesian” multipliers approach zero as the income elasticity of the demand for liquidity becomes very large and both monetary and fiscal policies lose effectiveness.  In this modified interpretation of the Economics of Depression, there is no free lunch for policy makers. Macroeconomic policies can only work to the extent they restore confidence in the future yield of capital assets.