Neutrality of money
Encyclopedia
Neutrality of money is the idea that a change in the stock of money affects only nominal variables in the economy such as price
s, 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.
, 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
).
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 very real psychological threshold.
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.
) and into real assets such as goods inventories
or even productive assets
. The shift in money demand can affect nominal interest rate
s 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.
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.
Price
-Definition:In ordinary usage, price is the quantity of payment or compensation given by one party to another in return for goods or services.In modern economies, prices are generally expressed in units of some form of currency...
s, wages and exchange rates, with no effect on real (inflation-adjusted) variables, like employment, real GDP
Real GDP
Real Gross Domestic Product is a macroeconomic measure of the value of output economy adjusted for price changes . The adjustment transforms the money-value measure, called nominal GDP, into an index for quantity of total output...
, and real consumption
Consumption (economics)
Consumption is a common concept in economics, and gives rise to derived concepts such as consumer debt. Generally, consumption is defined in part by comparison to production. But the precise definition can vary because different schools of economists define production quite differently...
.
Neutrality of money is an important idea in classical economics
Classical economics
Classical economics is widely regarded as the first modern school of economic thought. Its major developers include Adam Smith, Jean-Baptiste Say, David Ricardo, Thomas Malthus and John Stuart Mill....
and is related to the classical dichotomy
Classical dichotomy
In macroeconomics, the classical dichotomy refers to an idea attributed to classical and pre-Keynesian economics that real and nominal variables can be analyzed separately...
. It implies that the central bank
Central bank
A central bank, reserve bank, or monetary authority is a public institution that usually issues the currency, regulates the money supply, and controls the interest rates in a country. Central banks often also oversee the commercial banking system of their respective countries...
does not affect the real economy (e.g., the number of jobs
Employment
Employment is a contract between two parties, one being the employer and the other being the employee. An employee may be defined as:- Employee :...
, 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
Real business cycle theory
Real business cycle theory are a class of macroeconomic models in which business cycle fluctuations to a large extent can be accounted for by real shocks. Unlike other leading theories of the business cycle, RBC theory sees recessions and periods of economic growth as the efficient response to...
models) while others like monetarism
Monetarism
Monetarism is a tendency in economic thought that emphasizes the role of governments in controlling the amount of money in circulation. It is the view within monetary economics that variation in the money supply has major influences on national output in the short run and the price level over...
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 PatinkinDon Patinkin
Don Patinkin was an Israeli/American monetary economist, and the president of Hebrew University in Jerusalem.- Biography :...
, the concept of monetary neutrality goes back as far as David Hume
David Hume
David Hume was a Scottish philosopher, historian, economist, and essayist, known especially for his philosophical empiricism and skepticism. He was one of the most important figures in the history of Western philosophy and the Scottish Enlightenment...
. 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
Knut Wicksell
Johan Gustaf Knut Wicksell was a leading Swedish economist of the Stockholm school. His economic contributions would influence both the Keynesian and Austrian schools of economic thought....
).
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 theoryMonetary Disequilibrium Theory
Monetary disequilibrium theory is basically a product of the Monetarist school mainly represented in the works of Leland Yeager and Austrian macroeconomics...
applies, such that the nominal money supply
Money supply
In economics, the money supply or money stock, is the total amount of money available in an economy at a specific time. There are several ways to define "money," but standard measures usually include currency in circulation and demand deposits .Money supply data are recorded and published, usually...
would affect output. One argument is that prices and especially wages are 'sticky
Sticky (economics)
Sticky, in the social sciences and particularly economics, describes a situation in which a variable is resistant to change. Sticky prices are an important part of macroeconomic theory since they may be used to explain why markets might not reach equilibrium right away. Nominal wages are often said...
', 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
Menu costs
In economics, a menu cost is the cost to a firm resulting from changing its prices. The name stems from the cost of restaurants literally printing new menus, but economists use it to refer to the costs of changing nominal prices in general...
, etc) but that they don't realize that they should. The bounded rationality
Bounded rationality
Bounded rationality is the idea that in decision making, rationality of individuals is limited by the information they have, the cognitive limitations of their minds, and the finite amount of time they have to make a decision...
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
Search theory
In microeconomics, search theory studies buyers or sellers who cannot instantly find a trading partner, and must therefore search for a partner prior to transacting....
for a completed contract than without the monetary contraction. Furthermore, the floor
Floor function
In mathematics and computer science, the floor and ceiling functions map a real number to the largest previous or the smallest following integer, respectively...
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 very real psychological threshold.
The New Keynesian
New Keynesian economics
New Keynesian economics is a school of contemporary 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.Two main assumptions define the New...
research program in particular emphasizes models in which money is not neutral, and therefore monetary policy
Monetary policy
Monetary policy is the process by which the monetary authority of a country controls the supply of money, often targeting a rate of interest for the purpose of promoting economic growth and stability. The official goals usually include relatively stable prices and low unemployment...
can affect the real economy.
Post-Keynesian economics
Post-Keynesian economics
Post Keynesian economics is a school of economic thought with its origins in The General Theory of John Maynard Keynes, although its subsequent development was influenced to a large degree by Michał Kalecki, Joan Robinson, Nicholas Kaldor and Paul Davidson...
and monetary circuit theory
Monetary circuit theory
Monetary circuit theory is a heterodox theory of monetary economics, particularly money creation, often associated with the post-Keynesian school....
reject the neutrality of money, instead emphasizing the role that credit money
Credit money
Credit money is any claim against a physical or legal person that can be used for the purchase of goods and services. Examples of credit money include personal IOUs, and in general any financial instrument or bank money market account certificate, which is not immediately repayable in specie, on...
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 demandMoney demand
The demand for money is the desired holding of financial assets in the form of money: that is, cash or bank deposits. It can refer to the demand for money narrowly defined as M1 , or for money in the broader sense of M2 or M3....
) and into real assets such as goods inventories
Inventory
Inventory means a list compiled for some formal purpose, such as the details of an estate going to probate, or the contents of a house let furnished. This remains the prime meaning in British English...
or even productive assets
Physical capital
In economics, physical capital or just 'capital' refers to any already-manufactured asset that is applied in production, such as machinery, buildings, or vehicles. In economic theory, physical capital is one of the three primary factors of production, also known as inputs in the production function...
. The shift in money demand can affect nominal interest rate
Interest rate
An interest rate is the rate at which interest is paid by a borrower for the use of money that they borrow from a lender. For example, a small company borrows capital from a bank to buy new assets for their business, and in return the lender receives interest at a predetermined interest rate for...
s on loanable funds
Loanable funds
In economics, the loanable funds market is a hypothetical market that brings savers and borrowers together, also bringing together the money available in commercial banks and lending institutions available for firms and households to finance expenditures, either investments or consumption...
, 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
Durable good
In economics, a durable good or a hard good is a good that does not quickly wear out, or more specifically, one that yields utility over time rather than being completely consumed in one use. Items like bricks or jewellery could be considered perfectly durable goods, because they should...
can be affected.
Evidence
U.S. National Bureau of Economic ResearchNational Bureau of Economic Research
The National Bureau of Economic Research is an American private nonprofit research organization "committed to undertaking and disseminating unbiased economic research among public policymakers, business professionals, and the academic community." The NBER is well known for providing start and end...
member and International Monetary Fund
International Monetary Fund
The International Monetary Fund is an organization of 187 countries, working to foster global monetary cooperation, secure financial stability, facilitate international trade, promote high employment and sustainable economic growth, and reduce poverty around the world...
chief economist Olivier Blanchard
Olivier Blanchard
Olivier Jean Blanchard is currently the chief economist at the International Monetary Fund, a post he has held since September 1, 2008. He is also the Class of 1941 Professor of Economics at MIT, though he is currently on leave. Blanchard is one of the most cited economists in the world, according...
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
New Keynesian economics
New Keynesian economics is a school of contemporary 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.Two main assumptions define the New...
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
Fiat money
Fiat money is money that has value only because of government regulation or law. The term derives from the Latin fiat, meaning "let it be done", as such money is established by government decree. Where fiat money is used as currency, the term fiat currency is used.Fiat money originated in 11th...
is not.
See also
- Real versus nominal value (economics)
- Money illusionMoney illusionIn economics, money illusion refers to the tendency of people to think of currency in nominal, rather than real, terms. In other words, the numerical/face value of money is mistaken for its purchasing power...
- Veil of moneyVeil of moneyVeil of money describes a problem in economics, which centers on the question of whether money is a commodity like other commodities, such as oil or gold or food - or whether it has special properties....
- Classical dichotomyClassical dichotomyIn macroeconomics, the classical dichotomy refers to an idea attributed to classical and pre-Keynesian economics that real and nominal variables can be analyzed separately...
- Quantity theory of moneyQuantity theory of moneyIn monetary economics, the quantity theory of money is the theory that money supply has a direct, proportional relationship with the price level....