Monetary Neutrality

The Concept of Monetary Neutrality

The concept of monetary neutrality is one where the supply of money has no real effect on real GDP in the long run. If the money supply rises by 5%, the price level rises by 5% in the long run. If it rises by 50%, the price level rises by 50%. According to the classical model, money is neutral in the sense that a change in the money supply only affects the aggregate price level but not real values like real GDP, real consumption, or employment level in the long run.

This does not mean that we should not care about what happens in the short run or that the Federal Reserve and its monetary policy are inconsequential. Our lives take place in the short run, and as John Maynard Keynes so famously said:

In the short run, monetary policy can make the difference between whether we can avoid a recession or not, which has a huge impact on society. In the long run, however, the only thing that changes is the aggregate price level.

The Principle of Monetary Neutrality

The principle of monetary neutrality is that money does not have an impact on the economic equilibrium in the long run. If the supply of money increases and nothing but the price of goods and services increases proportionally in the long run, what happens to a nation's production possibilities curve? It stays the same since the amount of money in the economy does not directly translate to advancement in technology or an increase in production capability.

Many economists believe that money is neutral because changes in the money supply affect nominal values, not real values.

Money Neutrality Formula

There are two formulas that can demonstrate the neutrality of money:

• The formula from the quantity theory of money;
• The formula for calculating the relative price.

Let us examine both of them to see how they illustrate that money is neutral.

Monetary Neutrality: The Quantity Theory of Money

Monetary neutrality can be stated using the quantity theory of money. It states that the money supply in the economy is directly proportional to the general price level. This principle can be written as the following equation:

\(MV=PY\)

M represents the money supply.

V is the velocity of money, which is the ratio of nominal GDP to the money supply. Think of it as the speed at which money travels through the economy. This factor is held stable.

P is the aggregate price level.

Y is the output of an economy and is determined by technology and resources available, so it is also held stable.

Fig 1. The Quantity Theory of Money equation, StudySmarter Originals

We have \(P\times Y=\hbox{Nominal GDP}\). If V is held constant, then any changes in M equal the same percent change in \(P\times Y\). Since money is neutral, it wouldn't affect Y, leaving us with whatever changes in M resulting in an equal percentage change in P. This shows us how a change in the money supply will affect nominal values like nominal GDP. If we account for the changes in the aggregate price level, we end up with no change in the real value.

Monetary Neutrality: Calculating Relative Price

We can calculate the relative price of goods to demonstrate the principle of monetary neutrality and how it might look in real life.

\(\frac{\hbox{Price of Good A}}{\hbox{Price of Good B}}=\hbox{Relative price of Good A in terms of Good B}\)

Then, a change in the money supply takes place. Now, we take a look at the same goods after a percent change in their nominal price and compare the relative price.

An example might demonstrate this better.

The relative price of 2 pencils per apple did not change, demonstrating the idea that only nominal values are impacted by changes in the money supply. This can be taken as evidence that changes in the supply of money, in the long run, have no real impact on economic equilibrium except for the nominal price level. This is important for the economy in the long run because it indicates that the power of money has a limit. Money can affect the prices of goods and services, but it cannot change the nature of the economy itself.

Monetary Neutrality Example

Let's look at a monetary neutrality example. It is important to understand the long-run impact of a change in the money supply. In the first example, we will see a scenario where the Federal Reserve has implemented an expansionary monetary policy where the money supply is increased. This encourages both consumer and investment spending, driving up aggregate demand and GDP in the short run.

We can see this effect in action using a graph, but first, let us look at an example of what might happen if a contractionary monetary policy is implemented. A contractionary monetary policy is when the money supply is decreased to reduce consumer spending, reduce investment spending, and thereby decrease aggregate demand and GDP in the short run.

Monetary Neutrality: Graph

When depicting monetary neutrality on a graph, the money supply is vertical since the quantity of money supplied is set by the central bank. The interest rate is on the Y-axis because it can be thought of as the price of money: the interest rate is the cost that we have to consider when looking to borrow money.

Fig 2. Change in the supply of money and the effect on the interest rate, StudySmarter Originals

Let's break down figure 2. The economy is in equilibrium at E₁, where the money supply is set at M₁. The interest rate is determined by where money supply and money demand intersect, at r₁. Then the Federal Reserve decides to enact an expansionary monetary policy by increasing the supply of money from MS₁ to MS₂, which pushes the interest rate down from r₁ to r₂ and moves the economy to a short-run equilibrium of E₂.

However, in the long run, prices will increase by the same proportion as the increase in the money supply. This rise in the aggregate price level means that the demand for money will have to increase in proportion as well, from MD₁ to MD₂. This last shift then brings us to a new long-run equilibrium at E₃ and back to the original interest rate at r₁. From this, we can also conclude that in the long run, the interest rate is not affected by the supply of money because of monetary neutrality.

The Neutrality and Non-Neutrality of Money

The neutrality and non-neutrality of money as concepts belong to the classical and the Keynesian models, respectively.

Table 1 identifies the differences in the classical and Keynesian models that lead Keynes to arrive at a different conclusion on monetary neutrality.

The classical model states that money is neutral in that it does not affect real variables, only nominal variables. The main purpose of money is to set the price level. The Keynesian model states that the economy will experience monetary neutrality when there is full employment and when the economy is in equilibrium. But, Keynes argues that the economy experiences inefficiencies and is susceptible to people's emotions of optimism and pessimism that prevents the market from always being in equilibrium and having full employment.

When the market is not in equilibrium and is not experiencing full employment, money is not neutral,² and will have a non-neutral effect as long as there is unemployment, changes to the supply of money will impact real unemployment, real GDP, and the real interest rate.