Neutrality of Money - Explained

What is the Neutrality of Money Theory?

Updated at March 29th, 2023

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What is the Neutrality Of Money?

The neutrality of money is a theory that maintains that changes in the supply of money in an economy only affect nominal variables and not real variables. This means that when the Cbetra bank decides to change the supply of money, nominal variables such as prices, wages, and exchange rates are affected and not the real economic variables. Real economic variables include employment, consumption and real gross domestic product (GDP). Changes in money supply in an economy can either be a decrease o an increase in the supply of money, when this happens, the GDP, structure and other real variables of the economy are unaffected.

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How does the Neutrality Of Money Work?

There are some adjustments made to the modern versions of the neutrality of money theory, for instance, the modern version states that employment and output which are real variables of an economy can be affected by changes in money supply but only for a short period. The neutrality of money is otherwise called neutral money, this theory states that changes in money supply can affect the prices of goods and services and not real economic variables. Hence, the underlying structure and conditions of an economy do not change when a change occurs in the supply of money.

History and Meaning

Friedrich A. Hayek, an Austrian economist formally introduced the term neutrality of money was in 1931. After its introduction, the phrase was adopted by neoclassical and neo-Keynesian economists who applied it in the general equilibrium theory. The initial origin of the neutrality of money can be traced to the Cambridge tradition, this earliest version of the theory emerged between 1750 and 1870. When it was first used, the neutrality of money believes that changes in money supply cannot in any way affect economic output or employment, this later changed in the later centuries as it posited that these changes could affect output and employment in the short run.

Long-Run Money Neutrality

In reality, economists do not buy the idea of short-run money neutrality, rather, their position is that of long-run money neutrality. Macroeconomic theories underpin the assumption of long-run money neutrality, this is to show the long-term effect of economic and monetary policy on the economy. However, macroeconomists do not assume that changes in the supply of money would affect employment rate, output or real variables in the long-run. Criticisms There are some economists and economics schools that are not in favor of the neutrality of money both in its long-run and short-run forms. Generally, the Post-Keynesian school of economics and the Austrian school of economics are strong against the neutrality of money. Economists such as Paul Davidson, Ludwig von Mises, and many others are critics of this theory.

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neutrality of money monetary neutrality

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