Definition
The neutrality of money is an economic theory asserting that changes in the money supply only affect nominal variables and do not influence real variables such as employment, real GDP, or consumption. In other words, it means that injecting additional money into an economy will only cause price levels to increase, but will not boost economic output or change people’s consumption habits. This principle is fundamental to classical and neoclassical economics.
Phonetic
The phonetic pronunciation for “Neutrality Of Money” would be: /nuːˌtræləti ʌv ˈmʌni/
Key Takeaways
Here are three main takeaways about Neutrality of Money:
- Definition: The neutrality of money implies that the monetary change in an economy including a change in the money supply or monetary policy does not have an effect on real variables such as employment, real GDP, or real investment. It only affects nominal variables like the price level, inflation rate, and nominal wages.
- Long Run Perspective: In macroeconomic models, money is usually neutral in the long run. This means that if the money supply doubles, all prices will double, but real GDP and other real measures will remain unchanged. That implies that monetary policy can’t impact the long-term growth rate of the economy.
- Short Run Non-neutrality: In contrast to the long run, money is often assumed to be non-neutral in the short run. This means that changes in the money supply can cause fluctuations in real GDP and employment levels in the short run. This assumption forms the basis for active monetary policy conducted by central banks to manage business cycles.
Importance
The concept of Neutrality of Money is important in the field of business and finance as it asserts that changes in the money supply only affect nominal variables (like prices, wages, and exchange rates), and have no long-term impact on real variables (such as employment, real GDP, and real consumption). According to this theory, adjustments in the quantity of money only change the price level but do not influence the economic output. Thus, central banks can control inflation in the long run, but not real economic variables. This understanding aids policymakers in making more informed decisions regarding monetary policy, and avoids misinterpreting temporary monetary fluctuations as permanent economic changes.
Explanation
At the heart of economic theory and policy decisions, the concept of Neutrality of Money plays an essential role. By central tenet, neutrality of money indicates that changes in the overall supply of money impact nominal variables like wages and prices, but do not have real economic effects such as the total output of goods and services, employment, or investments. This principle implies that the monetary policy has no influence over the real economic factors in the long run, and suggest that changing the money supply can at best affect the price levels while leaving the real economic factors unchanged.The purpose of the concept of money neutrality is to guide monetary policy decision making within central banks. By understanding that changes to the money supply will not affect real economic outcomes in the long term, it is then utilized by central banks to manage inflation. For instance, if economy is faced with rising inflation, central banks can utilize their tools to contract the money supply with the understanding that while this may increase interest rates and decrease price levels, it will not negatively impact the overall economy in the long run. Therefore, the neutrality of money forms an essential guidepost for central banking policies, helping to separate fiscal and monetary policies.
Examples
Neutrality of Money is an economic theory asserting that changes in the overall money supply do not impact real economic variables such as output, employment, or real GDP, but only nominal variables like price levels, inflation, and nominal wage rates. Here are three examples:1. The Great Depression: The Great Depression that began in 1929 is an example often used in discussing neutrality of money. The economic downturn occurred when the Federal Reserve System unexpectedly contracted the money supply, leading to a collapse of asset prices. However, when the money supply was eventually increased, it didn’t immediately result in recovery. This showed that changes in the money supply did not have an immediate and proportional effect on real economic variables.2. Japanese Economy in 1990s: The Japanese asset price bubble collapsed in the early 1990s, and the Bank of Japan responded by significantly increasing the money supply to stimulate the economy. However, Japan still faced stagnation and deflation for over a decade, indicating that the expansion of the nominal money supply did not lead to direct improvements in real economic performance.3. Quantitative Easing in recent times: Central banks, including the US Federal Reserve, implemented quantitative easing (special type of monetary policy where central bank purchases government securities or other securities from the market) to deal with the 2008 financial crisis and recent COVID-19 pandemic. By doing so, they significantly increased the money supply. While this has helped in current circumstances to some extent, it has not resulted in an immediate, proportional increase in real GDP or employment, showing the neutrality of money in the short run. Most of the effects have been seen in nominal variables like inflation and asset prices.
Frequently Asked Questions(FAQ)
What is the Neutrality of Money?
The Neutrality of Money is an economic concept that suggests changes in the money supply only impact the nominal variables (like exchange rates, prices, and wages), and have no effect on the real economic variables such as real GDP, real interest rates, and employment levels in an economy.
Who proposed the theory of the Neutrality of Money?
The concept of the Neutrality of Money can be traced back to classical economists, like David Hume and John Locke, but the term was made popular by Austrian economists in the early 20th century.
Is the concept of the Neutrality of Money universally accepted?
No, this concept is not universally accepted. While classical and new classical economists agree with this theory, other economists, including the Keynesians, monetarists, and modern theorists, often argue that money is not neutral, especially in the short run.
How can the Neutrality of Money be applied in the real world?
If the Neutrality of Money holds true, it implies that monetary policy cannot influence real economic activity, such as increasing production or reducing unemployment. It would only impact nominal variables like inflation and nominal interest rates.
What is the importance of the Neutrality of Money in economic policy?
Understanding this theory is important as it can influence how policymakers use monetary policy to steer the economy. If the economy exhibits long-term neutrality, it means real variables are not affected by changes in the money supply, and central banks should focus on controlling inflation instead of impacting real economic growth.
What is the difference between the Neutrality of Money and the Superneutrality of Money?
The Neutrality of Money states that changes in the money supply will only affect nominal variables and won’t affect real variables. In contrast, the Superneutrality of Money states that even the growth rate of the money supply does not affect real variables.
What are real variables and nominal variables in the context of the theory of the Neutrality of Money?
Real variables are metrics that are adjusted for inflation, such as real GDP and real interest rate. Nominal variables, on the other hand, are not adjusted for inflation and include metrics such as nominal GDP, nominal interest rate, and price levels.
Related Finance Terms
- Monetary Policy
- Inflation
- Real and Nominal Variables
- Keynesian Economics
- Quantity Theory of Money
Sources for More Information
