Editing Keynesian economics (section)

===<span id=liquiditytrap>The liquidity trap</span>===
[[File:Keynesliquiditytrap.svg|class=skin-invert-image|thumb|The liquidity trap]]The [[liquidity trap]] is a phenomenon that may impede the effectiveness of monetary policies in reducing unemployment.

Economists generally think the rate of interest will not fall below a certain limit, often seen as zero or a slightly negative number. Keynes suggested that the limit might be appreciably greater than zero but did not attach much practical significance to it. The term "liquidity trap" was coined by [[Dennis Robertson (economist)|Dennis Robertson]] in his comments on the ''General Theory'',<ref>D. H. Robertson, "Some Notes on Mr. Keynes' General Theory of Interest", ''Quarterly Journal of Economics'', 1936</ref> but it was [[John Hicks]] in "[[Mr Keynes and the Classics|Mr. Keynes and the Classics]]"<ref>"Mr. Keynes and the 'Classics'; A Suggested Interpretation", ''Econometrica'', 1937.</ref> who recognised the significance of a slightly different concept.

If the economy is in a position such that the liquidity preference curve is almost vertical, as must happen as the lower limit on ''r'' is approached, then a change in the money supply ''M̂'' makes almost no difference to the equilibrium rate of interest ''r̂'' or, unless there is compensating steepness in the other curves, to the resulting income ''Ŷ''. As Hicks put it, "Monetary means will not force down the rate of interest any further."

Paul Krugman has worked extensively on the liquidity trap, claiming that it was the problem confronting the Japanese economy around the turn of the millennium.<ref>P. R. Krugman, "It's baaack: Japan's slump and the return of the liquidity trap," ''Brookings papers on economic activity'', 1998.</ref> In his later words:
<blockquote>Short-term interest rates were close to zero, long-term rates were at historical lows, yet private investment spending remained insufficient to bring the economy out of deflation. In that environment, monetary policy was just as ineffective as Keynes described. Attempts by the Bank of Japan to increase the money supply simply added to already ample bank reserves and public holdings of cash...<ref>P. R. Krugman, Introduction to the ''General Theory''..., 2008.</ref></blockquote>

====<span id=islm>The IS–LM model</span>====
[[File:Keynesislm.svg|class=skin-invert-image|thumb|IS–LM plot]]

Hicks showed how to analyse Keynes' system when liquidity preference is a function of income as well as of the rate of interest. Keynes's admission of income as an influence on the demand for money is a step back in the direction of classical theory, and Hicks takes a further step in the same direction by generalizing the propensity to save to take both ''Y'' and ''r'' as arguments. Less classically he extends this generalization to the schedule of the marginal efficiency of capital.

The [[IS–LM model|IS-LM model]] uses two equations to express Keynes' model. The first, now written ''I'' (''Y'', ''r'' ) = ''S'' (''Y'',''r'' ), expresses the principle of effective demand. We may construct a graph on (''Y'', ''r'' ) coordinates and draw a line connecting those points satisfying the equation: this is the ''IS'' curve. In the same way we can write the equation of equilibrium between liquidity preference and the money supply as ''L''(''Y'' ,''r'' ) = ''M̂'' and draw a second curve – the ''LM'' curve – connecting points that satisfy it. The equilibrium values ''Ŷ'' of total income and ''r̂'' of interest rate are then given by the point of intersection of the two curves.

If we follow Keynes's initial account under which liquidity preference depends only on the interest rate ''r'', then the ''LM'' curve is horizontal.

[[Joan Robinson]] commented that:
<blockquote>... modern teaching has been confused by J. R. Hicks' attempt to reduce the ''General Theory'' to a version of static equilibrium with the formula IS–LM. Hicks has now repented and changed his name from J. R. to John, but it will take a long time for the effects of his teaching to wear off.</blockquote>

Hicks subsequently relapsed.<ref>Richard Kahn, ''The Making of Keynes' General Theory'', pp. 160 and 248.</ref>{{Clarify|date=November 2021}}