The Neutrality of Money: An Economic Insight
The neutrality of money, also referred to as neutral money, is an idea in economics which posits that changes in the money supply affect nominal variables, such as prices and wages, but do not influence real variables like economic output or the structure of the economy. Essentially, while central banks like the Federal Reserve may print more money and influence price levels and wages, this change does not alter the economy’s underlying conditions.
Modern interpretations of this theory recognize that while changes in the money supply might impact output and employment levels in the short term, many economists concur that these changes do not influence the economy in the long run.
Key Takeaways
- The theory of money neutrality suggests that adjustments in the money supply affect the prices of goods, services, and wages without changing overall economic productivity.
- Changes in money supply do not alter the fundamental conditions of the economy; hence, aggregate supply should remain unaffected.
- While short-term impacts on output may be seen, many economists argue that long-term neutrality of money underpins numerous macroeconomic theories.
- Critics argue that the theory overlooks the long-term implications on prices, consumption, and production.
- The concept of money neutrality was first introduced by Austrian economist Friedrich A. Hayek in 1931.
Understanding the Neutrality of Money
The neutrality of money is based on the belief that money is a ’neutral’ factor, having no real impact on economic equilibrium. Printing more money may increase the prices of goods, services, and wages, but it does not fundamentally change the economy’s structure. According to this theory, all markets for goods adjust continually towards equilibrium, and changes in money supply do not impact the economy’s core conditions.
By this notion, aggregate supply should remain consistent, as new money neither creates nor destroys machinery, introduces new trading partners, nor affects existing knowledge and skills.
An illustrative example can be seen when examining the monetary policy of central banks like the Federal Reserve. When the Federal Reserve engages in open market operations, it is presumed that the changes in money supply do not affect long-term capital equipment, employment levels, or real wealth. This viewpoint provides economists with stable parameters for making predictions.
Origins of the Neutrality of Money Concept
The theory of money neutrality has its roots in the Cambridge tradition of economics, spanning from 1750 to 1870. The original concept suggested that the level of money in an economy would not affect output or employment in either the short or long term. According to this view, since the aggregate supply curve is vertical, a change in the price level does not shift the aggregate output.
Although some classical economists rejected this view, citing short-term factors like price stickiness or depressed business confidence, the theory gained prominence later.
The term ’neutrality of money’ was coined by Austrian economist Friedrich A. Hayek in 1931. Initially, Hayek described it as a scenario where the interest rate did not lead to poorly allocated business decisions (‘malinvestments’), a concept related to Austrian business cycle theory.
Neutrality of Money vs. Superneutrality of Money
Superneutrality is a stronger stance than the neutrality of money postulate, assuming that changes in the rate of money supply growth do not affect economic output. According to this theory, money growth has no real impact except on real money balances. The concept is generally applied to economies used to a constant money growth rate.
Criticism of the Neutrality of Money
Despite its academic significance, the neutrality of money theory has its detractors. Critics including John Maynard Keynes, Ludwig von Mises, and Paul Davidson, along with the Post-Keynesian and Austrian schools of economics, reject the theory.
Their primary argument asserts that an increase in the money supply ultimately decreases the value of money. Over time, as money circulates through the economy, prices of goods and services rise to counter the increased money supply. Similarly, increasing the money supply affects consumption and production, as it alters how individuals and businesses interact with the economy.
Related Terms: money supply, nominal variables, Federal Reserve, central banks, economic equilibrium.
