Neutrality of money
Neutrality of money is the idea that a change in the stock of money affects only nominal variables in the economy such as prices, wages, and exchange rates, with no effect on real (inflation-adjusted) variables, like employment, real GDP, and real consumption.
Neutrality of money is an important idea in classical economics and is related to the classical dichotomy. It implies that the central bank does not affect the real economy (e.g., the number of jobs, the size of real GDP, the amount of real investment) by printing money. Instead, any increase in the supply of money would be offset by a proportional rise in prices and wages. This assumption underlies some mainstream macroeconomic models (e.g., real business cycle models) while others like monetarism view money as being neutral in the long-run.
Superneutrality of money is a stronger property than neutrality of money. It holds that not only is the real economy unaffected by the level of the money supply but also that the rate of money supply growth has no effect on real variables. In this case, nominal wages and prices remain proportional to the nominal money supply not only in response to one-time permanent changes in the nominal money supply but also in response to permanent changes in the growth rate of the nominal money supply. Typically superneutrality is addressed in the context of long-run models.
History of the concept
According to Don Patinkin, the concept of monetary neutrality goes back as far as David Hume. The term itself was first used by continental economists beginning at the turn of the 20th century, and exploded as a special topic in the English language economic literature upon Friedrich Hayek's introduction of the term and concept in his famous 1931 LSE lectures published as Prices and Production. Keynes rejected neutrality of money both in the short term and in the long term.
Views & Counter Views
Many economists maintain that money neutrality is a good approximation for how the economy behaves over long periods of time but that in the short run monetary-disequilibrium theory applies, such that the nominal money supply would affect output. One argument is that prices and especially wages are sticky (because of menu costs, etc.), and cannot be adjusted immediately to an unexpected change in the money supply. An alternative explanation for real economic effects of money supply changes is not that people cannot change prices but that they do not realize that it is in their interest to do so. The bounded rationality approach suggests that small contractions in the money supply are not taken into account when individuals sell their houses or look for work, and that they will therefore spend longer searching for a completed contract than without the monetary contraction. Furthermore, the floor on nominal wages changes imposed by most companies is observed to be zero: an arbitrary number by the theory of monetary neutrality but a psychological threshold due to money illusion.
Post-Keynesian economics and monetary circuit theory reject the neutrality of money, instead emphasizing the role that bank lending and credit play in the creation of bank money. Post-Keynesians also emphasize the role that nominal debt plays: since the nominal amount of debt is not in general linked to inflation, inflation erodes the real value of nominal debt, and deflation increases it, causing real economic effects, as in debt-deflation.
Reasons for departure from superneutrality
Even if money is neutral, so that the level of the money supply at any time has no influence on real magnitudes, money could still be non-superneutral: the growth rate of the money supply could affect real variables. A rise in the monetary growth rate, and the resulting rise in the inflation rate, lead to a decline in the real return on narrowly defined (zero-nominal-interest-bearing) money. Therefore people choose to re-allocate their asset holdings away from money (that is, there is a decrease in real money demand) and into real assets such as goods inventories or even productive assets. The shift in money demand can affect nominal interest rates on loanable funds, and the combined changes in the nominal interest rate and the inflation rate may leave real interest rates changed from previously. If so, real expenditure on physical capital and durable consumer goods can be affected.
- Real versus nominal value (economics)
- Money illusion
- Veil of money
- Classical dichotomy
- Quantity theory of money
- Patinkin, Don (1987), Neutrality of Money, Palgrave
- See David Laidler (1992). "Hayek on Neutral Money and the Cycle," UWO Department of Economics Working Papers #9206. and Roger Garrison & Israel Kirzner. (1987). "Friedrich August von Hayek," John Eatwell, Murray Milgate, and Peter Newman, eds. The New Palgrave: A Dictionary of Economics London: Macmillan Press Ltd., 1987, pp. 609–614
- See the Google NGRAM for 'neutral money' http://books.google.com/ngrams/graph?content=neutral+money%2Cneutrality+of+money&year_start=1800&year_end=2000&corpus=15&smoothing=1&share=
- The Collected Writings, vol 13, pp. 408-411
- Cargill, Thomas, and Robert Meyer, "Intertemporal stability of the relationship between interest rates and price changes," Journal of Finance 32, September 1977, 1001–1015.
- Fried, Joel, and Peter Howitt, "The effects of inflation on real interest rates," American Economic Review 73, December 1983, 968–980.
- Levi, Maurice, and John Makin, "Fisher, Phillips, Friedman, and the measured impact of inflation on interest," Journal of Finance 34, March 1979, 35–52.
- Mundell, Robert, "Inflation and real interest," Journal of Political Economy 71, June 1963, 280–283.
- Mitchell, Douglas W., "Expected inflation and interest rates in a multi-asset model: a note," Journal of Finance 40, June 1985, 595–599.
- Don Patinkin (1987). "Neutrality of money," The New Palgrave: A Dictionary of Economics, v. 3, pp. 639–44. Reprinted in John Eatwell et al. (1989), Money: The New Palgrave, p p. 273--  287.
- Friedrich Hayek (1931) Prices and Production. London: G. Routledge & Sons.
- Friedrich Hayek (1933 in German). "On 'Neutral Money'," in F. A. Hayek. Money, Capital, and Fluctuations: Early Essays, edited by Roy McCloughry, Chicago, University of Chicago Press, 1984.
- David Laidler (1992). "Hayek on Neutral Money and the Cycle," UWO Department of Economics Working Papers #9206.
- Roger Garrison & Israel Kirzner. (1987). "Friedrich August von Hayek," John Eatwell, Murray Milgate, and Peter Newman, eds. The New Palgrave: A Dictionary of Economics London: Macmillan Press Ltd., 1987, pp. 609–614