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 an equal 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 economy neutral as to the level of the money supply but also that the rate of money supply growth has no effect on real variables. In this case, both the money supply and its growth rate can affect nominal variables such as the price level and inflation rate in the short run.

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 in the 1920s and 1930s by a variety of continental economists (but was mistakenly attributed by Friedrich von Hayek to Knut Wicksell). Keynes rejected neutrality of money both in the short term and in the long term.

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', and cannot be adjusted immediately to an unexpected change in the money supply. An alternative explanation for real economic effects from money supply changes is not that people can't change prices (because of menu costs, etc) but that they don't realize that they should. 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 money's neutrality but a psychological threshold due to money illusion.

The New Keynesian research program in particular emphasizes models in which money is not neutral, and therefore monetary policy can affect the real economy.

Post-Keynesian economics and monetary circuit theory reject the neutrality of money, instead emphasizing the role that credit money creation by banks plays in the economy. Post-Keynesians also emphasize the role that nominal debt plays: since nominal amount of debt are 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 minus the inflation rate this leads in turn to a decline in the real rate of return on 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.

Evidence

U.S. National Bureau of Economic Research member and International Monetary Fund chief economist Olivier Blanchard has said, there is no real evidence: "All the models we have seen impose the neutrality of money as a maintained assumption. This is very much a matter of faith, based on theoretical considerations rather than on empirical evidence." Recognition of the short-run non-neutrality of money led to the development of the New Keynesian class of macroeconomic models.

Empirical studies have shown that money is neutral in the long-run. Nonetheless, it is also true that the way in which money is supplied today, i.e. through debt, is actually affecting the economy and pushing for growth, both in the short and in the long run (see Critics to fractional reserve banking). It can therefore be argued that while sound money is neutral over the long term, fiat money is not.

See also

• Real versus nominal value (economics)
• Money illusion
• Veil of money
• Classical dichotomy
• Quantity theory of money

References

• 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, pp. 273-- [1] 287.
• 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