Monetary Neutrality

We hear all the time that wages are not keeping up with prices! That if we keep printing money, it won't be worth anything! How are we all supposed to manage when rent is rising and wages are stagnant!? These are all incredibly valid and real questions to ask, especially when they are so pertinent to our everyday lives. 

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    However, from an economic standpoint, these are short-run issues that iron themselves out in the long run. But how? Monetary neutrality is how. But that answer is not very helpful... What is helpful is our explanation of the concept of monetary neutrality, its formula, and much much more! Let's have a look!

    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.

    Monetary neutrality is the idea that a change in the money supply does not have a real impact on the economy in the long run, other than changing the aggregate price level in proportion to the change in the money supply.

    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 long run, we are all dead.

    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.

    Let's say that the money supply in the eurozone rises by 5%. At first, this increase in the supply of the Euro causes interest rates to decrease. Over time, prices will increase by 5%, and people will demand more money to keep up with this rise in the aggregate price level. This then pushes the interest rate back up to its original level. We can then observe that prices rise the same amount as the supply of money, namely 5%. This indicates that money is neutral since the price level rises by the same amount as the increase in the money supply.

    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.

    Monetary Neutrality Diagram showing the quantity theory of money equation MV equals PY StudySmarterFig 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 money supply increases by 25%. The price of apples and pencils was initially $3.50 and $1.75, respectively. Then the prices went up by 25%. How did this affect relative prices?

    \(\frac{\hbox{\$3.50 per apple}}{\hbox{\$1.75 per pencil}}=\hbox{an apple costs 2 pencils}\)

    After nominal price rises by 25%.

    \(\frac{\hbox{\$3.50*1.25}}{\hbox{\$1.75*1.25}}=\frac{\hbox{\$4.38 per apple}}{\hbox{\$2.19 per pencil}}=\hbox{an apple costs 2 pencils}\)

    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.

    The Fed is worried that the economy is about to experience a downturn. To help stimulate the economy and protect the country from a recession, the Fed decreases the reserve requirement so that banks can loan out more money. The goal of the central bank is to increase the money supply by 25%. This encourages firms and people to borrow and spend money which stimulates the economy, preventing a recession in the short run.

    Eventually, prices will increase by the same proportion as the initial increase in the money supply - in other words, the aggregate price level will increase by 25%. As prices for goods and services increase, people and firms demand more money to pay for goods and services. This pushes the interest rate back to its original level before the Fed increases the money supply. We can see that money is neutral in the long run since the price level rises by the same amount as the increase in the money supply and the interest rate stays the same.

    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.

    Let's say that the European economy is heating up, and the European Central Bank wants to slow it down to maintain the stability of the countries in the eurozone. To cool it down, the European Central Bank raises the interest rates so that there is less money available for businesses and individuals in the eurozone to borrow. This reduces the money supply in the eurozone by 15%.

    Over time, the aggregate price level will fall in proportion to the decrease in the money supply, by 15%. As the price level decreases, firms and people will demand less money because they don't need to pay as much for goods and services. This will push down the interest rate until it reaches the original level.

    Monetary Policy

    Monetary policy is an economic policy that is intended to set about changes in the money supply to adjust interest rates and impact aggregate demand in the economy. When it causes the money supply to increase and lowers interest rates, which increases spending and, therefore, increases output, it is an expansionary monetary policy. The opposite is a contractionary monetary policy. The money supply decreases, and interest rates rise. This reduces overall spending and GDP in the short run.

    Neutral monetary policy, as defined by the Federal Reserve Bank of San Francisco, is when the federal funds rate is set so that it does not restrain or stimulate the economy.1 The federal funds rate is essentially the interest rate that the Federal Reserve charges banks on the federal funds market. When monetary policy is neutral, it causes neither an increase nor decrease in the money supply nor in the aggregate price level.

    There is actually a lot more to learn about monetary policy. Here are several explanations that you might find interesting and useful:

    - Monetary Policy

    - Expansionary Monetary Policy

    - Contractionary Monetary Policy

    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.

    Monetary Neutrality Graph showing the effect of an increase in the money supply on the interest rate StudySmarterFig 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.

    The Classical ModelThe Keynesian Model
    • Assumes that there is full employment and efficient use of resources.
    • Believes that prices respond to the market's demand and supply rapidly to maintain a constant equilibrium
    • Indefinite persistence of some level of unemployment.
    • Believes that external pressures on supply and demand might prevent the market from achieving equilibrium.
    Table 1. Differences between The Classical Model and The Keynesian Model on Monetary Neutrality, Source: University At Albany2

    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.

    To learn more about how the money supply plays an important role in the economy in the short run, read these explanations:

    - AD-AS Model

    - Short-Run Equilibrium in the AD-AS Model

    Monetary Neutrality - Key takeaways

    • Monetary neutrality is the idea that a change in the aggregate money supply does not impact the economy in the long run, other than changing the aggregate price level in proportion to the change in the money supply.
    • Because money is neutral, it wouldn't affect the level of output an economy produces, leaving us with that whatever changes in the money supply will have an equal percentage change in the price, since the velocity of money is also constant.
    • The classical model states that money is neutral, whereas the Keynesian model disagrees in that money is not always neutral.

    References

    1. Federal Reserve Bank of San Francisco, What is Neutral Monetary Policy?, 2005, https://www.frbsf.org/education/publications/doctor-econ/2005/april/neutral-monetary-policy/#:~:text=In%20a%20sentence%2C%20a%20so,hitting%20the%20brakes)%20economic%20growth.
    2. University At Albany, 2014, https://www.albany.edu/~bd445/Economics_301_Intermediate_Macroeconomics_Slides_Spring_2014/Keynes_and_the_Classics.pdf
    Frequently Asked Questions about Monetary Neutrality

    What is monetary neutrality? 

    Monetary Neutrality is the idea that a change in the money supply does not impact the economy in the long run, other than changing the price level in proportion to the change in the money supply. 

    What is neutral monetary policy? 

    A neutral monetary policy is when the interest rate is set so that it does not restrain or stimulate the economy. 


    What is money neutrality in the classical model? 

    The classical model states that money is neutral in that it has no effect on real variables, only nominal variables. 

    Why is monetary neutrality important in the long run? 

    It is important in the long run because it indicates that the power of monetary policy has a limit. Money can affect the prices of goods and services but it cannot change the nature of the economy itself.  

    Does money neutrality affect interest rates? 

    Money neutrality means that the supply of money will not have an impact on the real interest rate in the long run.  

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