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History of Political Economy Annual Supplement to Volume 36 (2004) 92-126

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The IS-LM Model and the Liquidity Trap Concept:

From Hicks to Krugman

The General Theory of Employment is the Economics of Depression.
—John Hicks, "Mr. Keynes and the ‘Classics': A Suggested Interpretation" (1937)
Depression economics is back.
—Paul Krugman, The Return of Depression Economics (2000)

One main feature of John Hicks's 1937 "Mr. Keynes and the ‘Classics'" is the identification of the assumption that there is a floor to the rate of interest on the left part of the LM curve as the central difference between John Maynard Keynes's 1936 General Theory and "classical" economics, a judgment that Hicks repeated on other occasions ([1939] 1946, 1950, 1957). The notion of a "liquidity trap"—a phrase coined by Dennis Robertson (1936, 1940), albeit in a different context, as discussed below—was conspicuous in macroeconomic textbooks of the 1950s and 1960s (see, e.g., Hansen 1953, Ackley 1961, and Bailey 1962), but it gradually receded into the background until it came to the fore again in the recent literature triggered by the Japanese depression and the experience of low inflation and low nominal interest rates in the United States and Europe in the late 1990s (see, e.g., McKinnon and Ohno 1997, chap. 5; Fuhrer and Madigan 1997; Krugman 1998, [1999] 2000; special [End Page 92] issues of the Journal of Money, Credit, and Banking, November 2000, and of the Journal of the Japanese and International Economies, December 2000; Benhabib et al. 2002; Walsh 2003, chap. 10; Woodford 2003, chap. 2). The revival of interest in the notion of a liquidity trap as a constraint on the effectiveness of monetary policy is also visible in connection with references by modern textbooks to the Japanese depression (see, e.g., Gordon [1978] 2000, Froyen 2002, Gärtner 2003, Mankiw 2003, and Krugman and Obstfeld 2003).

Whereas the liquidity trap literature traditionally associated with Keynes 1936 and Hicks 1937 concerned the existence of a positive floor to the interest rate, a more recent approach investigates the possibility of a zero lower bound on interest rates. This is in part explained by the shift from Keynes's model—where the long-term interest rate is the relevant opportunity cost in money demand, and expectations about the future values of that long rate are assumed to be regressive or inelastic—to the formulation of money demand in terms of the short-term nominal interest rate, which affects the long rate through the expectations theory of the term structure of interest rates. However, it should be noted that the textbook IS-LM approach to the liquidity trap set off by Alvin Hansen (1949, 1953) is closer to Keynes's 1936 original exposition than to Hicks's 1937 reformulation, which is in some aspects similar to the modern discussion. As pointed out by Don Patinkin (1976, 113 n. 9), Hicks (1937) formulated the liquidity trap "in a notably less extreme form than that which later became the standard one of macroeconomic textbooks." Hicks based his formulation of the liquidity trap on the notion that the short-run nominal interest rate cannot be negative and that the long rate is formed by expectations about the future value of the short rate plus a risk premium. These ideas were fully developed in his 1939 classic Value and Capital, which Hicks was writing when he published the IS-LM article.

The purpose of the present essay is to examine how the development of the liquidity trap concept is associated with the interpretation of the IS-LM model in general and the LM curve in particular, with emphasis on the original formulation by Hicks and the new interpretation put forward by Paul Krugman and others. The 1937 article—and the liquidity trap concept in particular—is interpreted against the background of the notion of "elasticity of price expectations" developed in Value and Capital. Oskar Lange (1938) was the only author, besides Hicks, to stress the form of the...