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Money Neutrality

Overview

Neutrality of money is an economic theory stating that alterations in the aggregate supply of money only affects nominal variables, instead of real variables. Thus, when the money supply is increased, it will proportionately increase wages and prices but will not alter anything on real valuables. This is therefore considered a credible scenario over a long period of economic cycles.

In other words, neutrality of money is the notion that an alteration in the stock of money has an impact only on nominal variables in the economy such as wages, prices of goods and services, exchange rates etc, but has no impact on real variables. These real variables are those adjustable to inflation such as real Gross Domestic Produce (GDP), employment and real consumption of goods and services in the economy.

It is very rational, since central banks e.g. Federal Reserves monitor money supply that they step up through open market operations to alter the supply of money when conditions are thought to be necessary. However, neutrality of money maintains that the central bank and Federal Reserves of countries do not affect the real economy (in this case like the size of actual Gross Domestic Produce (GDP), the number of jobs and the amount of real investments) by printing money. This means that when they print more money (of course increasing the supply), it will be counterbalanced by an equal increase in wages and prices, and it will affect the real economic variables, albeit short term.

Superneutrality of Money

This is more stronger than neutrality of money as it maintains that the economy is not only neutral to the level of the supply of money but it also holds that the rate of growth at which money is supplied has no impact on real variables. This means that both the money supply growth rate and the actual money supply can affect nominal variables such as inflation rate and price levels but only in the short run.

Real Economic Effects from changes in Money supply

A majority of experts in economy argue that neutrality of money is a perfect approximation of how the economy acts over extended periods of time, citing that in the short run, the theory of monetary disequilibrium applies in that money will affect the output. A justification of this argument as cited by the economists is that prices, and more particularly wages tend to have some ‘stickiness’ and cannot be regulated immediately to an abrupt change in money supply. Practically, an employer can raise the wages, but it is virtually impossible to lower the wages, due to changes in money supply.

Equally, economists argue that individuals do not realize the need to change their prices when the supply of money changes. This is because little contractions in the money supply are never taken seriously by individuals e.g. when they are job hunting or selling their houses. Thus, people tend to spend longer periods of time searching for a ‘real’ completed money contract, under-looking the current minimal monetary contraction.

Additionally, the floor on changes in nominal wages which most companies impose is observed to be zero; a subjective number according to the theory of neutrality of money, but a real psychological edge.

Conclusion

The theory of neutrality of money is based on the idea that a change occurring in the money supply will not change the aggregate supply and demand of service, goods or technology. This is mainly because of imperfect flow of information in the marketplace and the cited price stickiness. Conversely, modern-day scientists argue that neutrality of money therefore applies only partially in today’s financial markets.

Tags: bank, jobs, market, money, price

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