Neutrality Of Money

The neutrality of money, also called neutral money, is an economic theory that states that changes in the money supply only affect nominal variables and not real variables. In other words, an increase or decrease in the money supply can change the price level but not the output or structure of the economy. In modern versions of money neutrality theory, changes in the money supply might affect output or unemployment levels in the short run only, but neutrality is still assumed in the long run after money circulates throughout the economy.

According to the neutrality of money theory, all markets for all goods clear continuously. Relative prices adjust flexibly and always towards equilibrium. Changes in the supply of money do not appear to change the underlying conditions in the economy. New money neither creates nor destroys machines, and it does not introduce new trading partners or affect existing knowledge and skill. As a result, aggregate supply should remain constant.

Conceptually, money neutrality grew out of the Cambridge tradition in economics between 1750 and 1870. The earliest version posited that the level of money could not affect output or employment even in the short run. Because the aggregate supply curve is presumed to be vertical, a change in the price level does not alter the aggregate output.

Adherents believed shifts in the money supply affect all goods and services proportionately and nearly simultaneously. However, many of the classical economists rejected this notion and believed short-term factors, such as price stickiness or depressed business confidence, were sources of non-neutrality.

The phrase “neutrality of money” was introduced by Austrian economist Friedrich A. Hayek in 1931, who originally defined it as a market rate of interest at which malinvestments (poorly allocated business investments according to Austrian business cycle theory) did not occur and did not produce business cycles. Later neoclassical and neo-Keynesian economists adopted the phrase and applied it to their general equilibrium framework, giving it its current meaning.

There is an even stronger version of the neutrality of money postulate: the superneutrality of money. Superneutrality further assumes that changes in the rate of money supply growth do not affect economic output.  Money growth has no impact on real variables except for real money balances.  This theory disregards short-run frictions and is pertinent to an economy accustomed to a constant money growth rate.

Essentially, no economist accepts short-run money neutrality. However, the assumption of long-run money neutrality underlies almost all macroeconomic theory. Mathematical economists rely on this classical dichotomy to predict the effects of economic policy.

Suppose a macroeconomist is studying the monetary policy of a central bank, such as the Federal Reserve (Fed). When the Fed engages in open market operations, the macroeconomist does not assume that changes in the money supply will change future capital equipment, employment levels, or real wealth in long-run equilibrium. This gives the economist a much more stable set of predictive parameters.

Many notable economists reject the neutrality of money in the short and long run, including John Maynard Keynes, Ludwig von Mises, and Paul Davidson. The post-Keynesian school and Austrian school of economics also reject it. Several econometric studies suggest that variations in the money supply affect relative prices over long periods of time.