Neutrality of money

Last updated March 26, 2023

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 variables, like employment, real GDP, and real consumption.^[1] 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 creating 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). Others like monetarism view money as being neutral only 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.^[3]

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^[4] and concept in his famous 1931 LSE lectures published as Prices and Production.^[5] Keynes rejected neutrality of money both in the short term and in the long term.^[6]

Views and counterviews

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.

Neutrality of money has been a central question for monetarism. The most important answers were elaborated within the framework of the Phillips curve. Milton Friedman, assuming adaptive expectations, distinguished a series of short-run Phillips curves and a long-run one, where the short-run curves were supposed to be the conventional, negatively sloped curves, while the long-run curve was actually a vertical line indicating the natural rate of unemployment. According to Friedman, money was not neutral in the short run, because economic agents, confused by the money illusion, always respond to changes in the money supply. If the monetary authority chooses to increase the stock of money and, hence, the price level, agents will be never able to distinguish real and nominal changes, so they will regard the increase in nominal wages as real modifications, so labour supply will also be boosted. However, this change is only temporary, since agents will soon realize the actual state of affairs. As the higher wages were accompanied by higher prices, no real changes in income occurred, that is, it was no need to increase the labour supply. In the end, the economy, after this short detour, will return to the starting point, or in other words, to the natural rate of unemployment.

New classical macroeconomics, led by Robert E. Lucas, also has its own Phillips curve. However, things are far more complicated in these models, since rational expectations were presumed. For Lucas, the islands model made up the general framework in which the mechanisms underlying the Phillips curve could be scrutinized. The purpose of the first Lucasian island model (1972) was to establish a framework to support the understanding of the nature of the relationship between inflation and real economic performance by assuming that this relation offers no trade-off exploitable by economic policy. Lucas' intention was to prove that the Phillips curve exists without existing. It has been a heritage that there is a trade-off between inflation and unemployment or real economic performance, so it is undoubted that there is a short run Phillips curve (or there are short run Phillips curves). Although there are fewer possible actions available for the monetary policy to conceit people in order to increase the labour supply, unexpected changes can always trigger real changes. But what is the ultimate purpose of the central bank when changing the money supply? For example, and mostly: exerting countercyclical control. Doing so, monetary policy would increase the money supply in order to eliminate the negative effects of an unfavourable macroeconomic shock. However, monetary policy is not able to utilize the trade-off between inflation and real economic performance, because there is no information available in advance about the shocks to eliminate. Under these conditions, the central bank is unable to plan a course of action, that is, a countercyclical monetary policy. Rational agents can be conceited only by unexpected changes, so a well-known economic policy is completely in vain. However, and this is the point, the central bank cannot outline unforeseeable interventions in advance, because it has no informational advantage over the agents. The central bank has no information about what to eliminiate through countercyclical actions. The trade-off between inflation and unemployment exists, but it cannot be utilized by the monetary policy for countercyclical purposes.^[7]

The New Keynesian research program in particular emphasizes models in which money is not neutral in the short run, 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 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 the supply of 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.^[8]^[9]^[10]^[11]^[12]

Notes

↑ Patinkin, Don (1987), Neutrality of Money, Palgrave
↑ Walsh, Carl E. (2010). Monetary Theory and Policy (PDF) (3 ed.). Cambridge, Massachusetts: The MIT Press. ISBN 9780262013772.
↑ Stefan Homburg (2015). Superneutrality of Money under Open Market Operations, IDEAS. Retrieved 18 January 2015.
↑ 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'
↑ The Collected Writings, vol 13, pp. 408–411
↑ Galbács, Peter (2015). The Theory of New Classical Macroeconomics. A Positive Critique. Contributions to Economics. Heidelberg/New York/Dordrecht/London: Springer. doi:10.1007/978-3-319-17578-2. ISBN 978-3-319-17578-2.
↑ Cargill, Thomas; Meyer, Robert (1977). "Intertemporal Stability of the Relationship Between Interest Rates and Price Changes". Journal of Finance . 32 (September 1977): 1001–1015. doi:10.1111/j.1540-6261.1977.tb03305.x.
↑ Fried, Joel; Howitt, Peter. "The effects of inflation on real interest rates". 73 (December 1983). American Economic Review: 968–980.{{cite journal}}: Cite journal requires |journal= (help)
↑ Levi, Maurice; Makin, John (1979). "Fisher, Phillips, Friedman, and the Measured Impact of Inflation on Interest". The Journal of Finance. 34 (March 1979): 35–52. doi:10.1111/j.1540-6261.1979.tb02069.x.
↑ Mundell, Robert (1963). "Inflation and Real Interest". Journal of Political Economy. 71 (June 1963): 280–283. doi:10.1086/258771. S2CID 153733633.
↑ Mitchell, Douglas W. (1985). "Expected Inflation and Interest Rates in a Multi-asset Model: A Note". The Journal of Finance. 40 (June 1985): 595–599. doi:10.1111/j.1540-6261.1985.tb04977.x.

Related Research Articles

Macroeconomics is a branch of economics that deals with the performance, structure, behavior, and decision-making of an economy as a whole. For example, using interest rates, taxes, and government spending to regulate an economy's growth and stability. This includes regional, national, and global economies.

In economics, stagflation or recession-inflation is a situation in which the inflation rate is high or increasing, the economic growth rate slows, and unemployment remains steadily high. It presents a dilemma for economic policy, since actions intended to lower inflation may exacerbate unemployment.

In economics, inflation is an increase in the general price level of goods and services in an economy. When the general price level rises, each unit of currency buys fewer goods and services; consequently, inflation corresponds to a reduction in the purchasing power of money. The opposite of inflation is deflation, a decrease in the general price level of goods and services. The common measure of inflation is the inflation rate, the annualized percentage change in a general price index. As prices faced by households do not all increase at the same rate, the consumer price index (CPI) is often used for this purpose. The employment cost index is also used for wages in the United States.

Full employment is a situation in which there is no cyclical or deficient-demand unemployment. Full employment does not entail the disappearance of all unemployment, as other kinds of unemployment, namely structural and frictional, may remain. For instance, workers who are "between jobs" for short periods of time as they search for better employment are not counted against full employment, as such unemployment is frictional rather than cyclical. An economy with full employment might also have unemployment or underemployment where part-time workers cannot find jobs appropriate to their skill level, as such unemployment is considered structural rather than cyclical. Full employment marks the point past which expansionary fiscal and/or monetary policy cannot reduce unemployment any further without causing inflation.

New Keynesian economics is a school of macroeconomics that strives to provide microeconomic foundations for Keynesian economics. It developed partly as a response to criticisms of Keynesian macroeconomics by adherents of new classical macroeconomics.

The Phillips curve is an economic model, named after William Phillips, that predicts a correlation between reduction in unemployment and increased rates of wage rises within an economy. While Phillips himself did not state a linked relationship between employment and inflation, this was a trivial deduction from his statistical findings. Paul Samuelson and Robert Solow made the connection explicit and subsequently Milton Friedman and Edmund Phelps put the theoretical structure in place.

Monetary policy is the policy adopted by the monetary authority of a nation to control either the interest rate payable for very short-term borrowing or the money supply, often as an attempt to reduce inflation or the interest rate, to ensure price stability and general trust of the value and stability of the nation's currency.

Nominal rigidity, also known as price-stickiness or wage-stickiness, is a situation in which a nominal price is resistant to change. Complete nominal rigidity occurs when a price is fixed in nominal terms for a relevant period of time. For example, the price of a particular good might be fixed at $10 per unit for a year. Partial nominal rigidity occurs when a price may vary in nominal terms, but not as much as it would if perfectly flexible. For example, in a regulated market there might be limits to how much a price can change in a given year.

Monetary disequilibrium theory is a product of the monetarist school and is mainly represented in the works of Leland Yeager and Austrian macroeconomics. The basic concepts of monetary equilibrium and disequilibrium were, however, defined in terms of an individual's demand for cash balance by Mises (1912) in his Theory of Money and Credit.

The policy-ineffectiveness proposition (PIP) is a new classical theory proposed in 1975 by Thomas J. Sargent and Neil Wallace based upon the theory of rational expectations, which posits that monetary policy cannot systematically manage the levels of output and employment in the economy.

In macroeconomics, the classical dichotomy is the idea, attributed to classical and pre-Keynesian economics, that real and nominal variables can be analyzed separately. To be precise, an economy exhibits the classical dichotomy if real variables such as output and real interest rates can be completely analyzed without considering what is happening to their nominal counterparts, the money value of output and the interest rate. In particular, this means that real GDP and other real variables can be determined without knowing the level of the nominal money supply or the rate of inflation. An economy exhibits the classical dichotomy if money is neutral, affecting only the price level, not real variables. As such, if the classical dichotomy holds, money only affects absolute rather than the relative prices between goods.

The veil of money is the property assumed by some economists whereby money is a commodity like other commodities – such as oil or gold or food – as opposed to its having special properties.

Advanced Placement (AP) Macroeconomics is an Advanced Placement macroeconomics course for high school students that culminates in an exam offered by the College Board.

The Lucas islands model is an economic model of the link between money supply and price and output changes in a simplified economy using rational expectations. It delivered a new classical explanation of the Phillips curve relationship between unemployment and inflation. The model was formulated by Robert Lucas, Jr. in a series of papers in the 1970s.

In monetary economics, the demand for money is the desired holding of financial assets in the form of money: that is, cash or bank deposits rather than investments. It can refer to the demand for money narrowly defined as M1, or for money in the broader sense of M2 or M3.

New classical macroeconomics, sometimes simply called new classical economics, is a school of thought in macroeconomics that builds its analysis entirely on a neoclassical framework. Specifically, it emphasizes the importance of rigorous foundations based on microeconomics, especially rational expectations.

The AD–AS or aggregate demand–aggregate supply model is a macroeconomic model that explains price level and output through the relationship of aggregate demand (AD) and aggregate supply (AS).

Non-accelerating inflation rate of unemployment (NAIRU) is a theoretical level of unemployment below which inflation would be expected to rise. It was first introduced as NIRU by Franco Modigliani and Lucas Papademos in 1975, as an improvement over the "natural rate of unemployment" concept, which was proposed earlier by Milton Friedman.

Macroeconomic theory has its origins in the study of business cycles and monetary theory. In general, early theorists believed monetary factors could not affect real factors such as real output. John Maynard Keynes attacked some of these "classical" theories and produced a general theory that described the whole economy in terms of aggregates rather than individual, microeconomic parts. Attempting to explain unemployment and recessions, he noticed the tendency for people and businesses to hoard cash and avoid investment during a recession. He argued that this invalidated the assumptions of classical economists who thought that markets always clear, leaving no surplus of goods and no willing labor left idle.

The Lucas aggregate supply function or Lucas "surprise" supply function, based on the Lucas imperfect information model, is a representation of aggregate supply based on the work of new classical economist Robert Lucas. The model states that economic output is a function of money or price "surprise". The model accounts for the empirically based trade off between output and prices represented by the Phillips curve, but the function breaks from the Phillips curve since only unanticipated price level changes lead to changes in output. The model accounts for empirically observed short-run correlations between output and prices, but maintains the neutrality of money in the long-run. The policy ineffectiveness proposition extends the model by arguing that, since people with rational expectations cannot be systematically surprised by monetary policy, monetary policy cannot be used to systematically influence the economy.

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, 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

This page is based on this Wikipedia article
Text is available under the CC BY-SA 4.0 license; additional terms may apply.
Images, videos and audio are available under their respective licenses.

[PatinkinPalgrave-1] Patinkin, Don (1987), Neutrality of Money, Palgrave

[2] Walsh, Carl E. (2010). Monetary Theory and Policy (PDF) (3 ed.). Cambridge, Massachusetts: The MIT Press. ISBN 9780262013772.

[3] Stefan Homburg (2015). Superneutrality of Money under Open Market Operations, IDEAS. Retrieved 18 January 2015.

[4] 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

[5] See the Google NGRAM for 'neutral money'

[6] The Collected Writings, vol 13, pp. 408–411

[7] Galbács, Peter (2015). The Theory of New Classical Macroeconomics. A Positive Critique. Contributions to Economics. Heidelberg/New York/Dordrecht/London: Springer. doi:10.1007/978-3-319-17578-2. ISBN 978-3-319-17578-2.

[8] Cargill, Thomas; Meyer, Robert (1977). "Intertemporal Stability of the Relationship Between Interest Rates and Price Changes". Journal of Finance . 32 (September 1977): 1001–1015. doi:10.1111/j.1540-6261.1977.tb03305.x.

[9] Fried, Joel; Howitt, Peter. "The effects of inflation on real interest rates". 73 (December 1983). American Economic Review: 968–980.{{cite journal}}: Cite journal requires |journal= (help)

[10] Levi, Maurice; Makin, John (1979). "Fisher, Phillips, Friedman, and the Measured Impact of Inflation on Interest". The Journal of Finance. 34 (March 1979): 35–52. doi:10.1111/j.1540-6261.1979.tb02069.x.

[11] Mundell, Robert (1963). "Inflation and Real Interest". Journal of Political Economy. 71 (June 1963): 280–283. doi:10.1086/258771. S2CID 153733633.

[12] Mitchell, Douglas W. (1985). "Expected Inflation and Interest Rates in a Multi-asset Model: A Note". The Journal of Finance. 40 (June 1985): 595–599. doi:10.1111/j.1540-6261.1985.tb04977.x.

[1]

[2]

[3]

[4]

[5]

[6]

[7]

[8]

[9]

[10]

[11]

[12]