Neutrality of Money
The neutrality of money is an economic theory that asserts changes in the money supply affect only nominal variables (like prices and wages) and not real variables (such as output, employment, or the economy’s productive capacity). While many economists accept a form of neutrality in the long run, the theory is widely debated because short-run frictions can cause money supply changes to influence real economic activity.
Key takeaways
- Neutrality of money: changes in money supply change nominal variables but leave real variables unchanged.
- Most proponents treat neutrality as a long-run outcome; short-run effects are commonly acknowledged.
- Superneutrality is a stronger claim: changes in the growth rate of money do not affect real variables.
- Critics argue price rigidities, expectations, and institutional factors can make money non-neutral even in the long run.
How the theory works
- Money is treated as “neutral”: it facilitates transactions but does not alter technology, capital, labor supply, or preferences.
- If money supply rises proportionally across the economy, relative prices stay the same and only the overall price level changes.
- In long-run equilibrium models (classical/real-business-cycle frameworks), monetary changes translate into proportional changes in nominal wages and prices, leaving real allocations unchanged.
- Example: a central bank’s open-market operations that expand money are assumed, in the long run, to change the price level but not long-term capital stock, productivity, or real wealth.
Historical background
- The idea traces to classical monetary thought (18th–19th centuries) that saw money as neutral for real output.
- The term “neutrality of money” was popularized in the 20th century and adopted into neoclassical general-equilibrium analysis.
- Different schools (Austrian, neoclassical, Keynesian) have used or critiqued the concept in distinct ways; Hayek coined a related usage in the early 1930s.
Neutrality vs. superneutrality
- Neutrality: a change in the level of money supply affects only nominal variables.
- Superneutrality: a change in the growth rate of the money supply likewise has no effect on real variables (except possibly real money balances). This stronger claim typically assumes no short-run frictions and a steady-state growth environment.
Criticisms and reasons money may be non-neutral
- Price stickiness: nominal prices and wages do not adjust instantly, so monetary changes can alter real wages, output, and employment in the short run.
- Expectations and information: imperfect information and changing expectations can cause monetary policy to influence real decisions.
- Distributional and institutional effects: monetary changes can shift wealth and credit conditions, affecting investment and consumption patterns.
- Empirical evidence: some econometric studies indicate long-run effects on relative prices and real variables, challenging strict neutrality.
- School-specific objections: Keynesians, post-Keynesians, and some Austrian economists reject neutrality in both short and long runs for various theoretical reasons.
Related concepts
- Long-run neutrality: the view that neutrality holds over extended periods even if short-run non-neutralities occur.
- Non-neutrality of money: the position that monetary changes produce lasting real effects.
- Price stickiness: resistance of nominal prices/wages to change, a key channel for short-run non-neutrality.
Conclusion
Neutrality of money is a foundational assumption in many macroeconomic models, useful for simplifying long-run analysis by separating real and nominal variables. However, real-world frictions—like price and wage rigidities, expectations, and institutional factors—mean monetary changes can and do affect real economic activity, especially in the short run. The debate centers on the magnitude and persistence of these effects and whether neutrality (or superneutrality) is a reasonable approximation for policy analysis.