Neutrality of Money Theory

The neutrality of money, also called neutral money, is an economic theory stating that changes in the money supply only affect nominal variables and not real variables. In other words, the amount of money printed by central banks can impact prices and wages but not the output or structure of the economy.

Modern versions of the theory accept that changes in the money supply might affect output or unemployment levels in the short run; however, many of today’s economists still believe that neutrality is assumed in the long run after money circulates throughout the economy.

The neutrality of money theory is based on the idea that money is a “neutral” factor that has no real effect on economic equilibrium. Printing more money cannot change the fundamental nature of the economy, even if it drives up demand and leads to an increase in the prices of goods, services, and wages.

According to the theory, all markets for all goods clear continuously. Relative prices adjust flexibly and always towards equilibrium. Changes in the supply of money do not appear to change the underlying conditions in the economy. New money neither creates nor destroys machines, and it does not introduce new trading partners or affect existing knowledge and skill. As a result, aggregate supply should remain constant.

Not every economist agrees with this way of thinking and those who do generally believe that the neutrality of money theory is only truly applicable over the long term. In fact, the assumption of long-run money neutrality underlies almost all macroeconomic theory. Mathematical economists rely on this classical dichotomy to predict the effects of economic policy.

An example of the neutrality of money can be seen if a macroeconomist is studying the monetary policy of a central bank, such as the Federal Reserve (Fed). When the Fed engages in open market operations, the macroeconomist does not assume that changes in the money supply will change future capital equipment, employment levels, or real wealth in long-run equilibrium. Those factors will remain constant. This gives the economist a much more stable set of predictive parameters. Conceptually, money neutrality grew out of the Cambridge tradition in economics between 1750 and 1870. The earliest version posited that the level of money could not affect output or employment even in the short run. Because the aggregate supply curve is presumed to be vertical, a change in the price level does not alter the aggregate output.

Adherents believed shifts in the money supply affect all goods and services proportionately and nearly simultaneously. However, many of the classical economists rejected this notion and believed short-term factors, such as price stickiness or depressed business confidence, were sources of non-neutrality.

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