Liquidity preference versus loanable funds, televised (wonkish, with video)

One of the key insights in Keynes’s General Theory — actually, THE key insight — was that the loanable funds theory of the interest rate was incomplete. Loanable funds says that the interest rate is determined by the supply of and demand for saving; Keynes pointed out that the supply of saving is endogenous, depending on the level of output. He even illustrated the point with a remarkably ugly diagram (scroll down a bit). Hicks later made things clearer with the concept of the “IS curve”, which shows how the equilibrium interest rate from loanable funds varies with the level of GDP.

To have a full (”general”) theory of interest, said Keynes, you need to add in liquidity preference — the demand for money — which Hicks represented with the “LM curve”. And under depression conditions, where you’re in a liquidity trap, the interest rate is entirely determined by liquidity preference, because the interest rate is zero and can go no lower.

All this is familiar stuff to economists, or should be. But you couldn’t see it on TV — until now.

I had a brief exchange with George Will yesterday (you don’t have to read the snark — just watch the clip) that was, I realized later, precisely about liquidity preference versus loanable funds.

The diagram below shows two hypothetical IS curves, one for 2006, when the US was arguably at full employment, one for this year. In either case government borrowing for stimulus would have the effect of shifting the IS curve right. And if we were at full employment, George Will’s point would have been correct: interest rates would have gone up, because central banks would have raised rates to choke off potential inflation.

But where we actually are is hard up against the zero lower bound. And a rightward shift of the IS curve won’t raise rates unless it’s big enough to push us to full employment, which doesn’t seem likely.

Yes, I’m aware that the distinction between short-term and long-term rates complicates this a bit. But that’s still the main point — and now it’s been expounded on TV!

http://krugman.blogs.nytimes.com/2009/02/23/liquidity-preference-versus-loanable-funds-televised-wonkish-with-video/?scp=1&sq=keynes%20diagram&st=cse