Neutrality of Money

What is the Neutrality of Money?

The neutrality of money is a belief that depicts the fact that any change in the supply of money has implications on price and wages while overall economic productivity remains unaffected or in other words, monetary supply has sufficient power to affect the cost of goods and services but it doesn’t have any impact on the overall economy.

It is a concept of classical economics. This theory is less relevant and more controversial in today’s world. Some economists even argue that this theory doesn’t work and if at all it does then it is only in the long term. The neutrality of money also states that the repurchase would neither increase the economy’s employee’s productivity nor increase the country’s GDP (gross domestic product).

How Does the Neutrality of Money Work?

Money can either be used for saving or spending purposes. The new money injected in the economy will tend to be deposited in the bank accounts and some of it will land in the hands of service providers, retailers, new employees, etc. The prices of products and services will shoot up with the enhancement in the demands of the same. The increased demand might also boost employment as the employers will feel the urge to hire more employees and the demand for employees will ultimately allow a rise in the wages.

Neutrality-of-Money

Types

It is of two types –

Neutrality of Money Types
  1. Nominal Variables: Wages, prices and exchange rates are fine examples of nominal variables.
  2. Real Variables: Output (Gross Domestic Product), employment, and the amount of real investment are fine examples of real variables.

Difference between Neutrality Of Money Vs Superneutrality of Money

The neutrality of money and the supernaturality of money are used for designing the long-term models for an economy. Superneutrality of money is a stronger concept in comparison to the concept of neutrality of money. Superneutrality of money concept outdoes the neutrality of money concept since it states that the changes in the money supply levels have no impact on the real economy.

Unlike the concept of money neutrality, the concept not supernaturality of money states that the prices and nominal wages remain proportional to the supply of money during one-time changes in the nominal supply of money and also during permanent changes with respect to the rate of growth of nominal supply of money.

The Criticism of Money Neutrality

  • Outdated Concept: Economists criticize the concept of money neutrality for it is based on the quantity theory of money which happens to be an outdated concept. The Economists discarded the existence of the money neutrality concept since they believe that it has zero relevance in the modern economy.
  • Money Neutrality Doesn’t Guarantee Price Stability: The concept of money neutrality doesn’t ensure price stability and in a modern economy where scientific and technological developments have a vital role to play in enhancing production, and in such a case if the quantity of money remains constant then it would only result in deflationary conditions which will ultimately result in fall of prices.
  • The Money Neutrality Concept Cannot Be Used During Depression: The policy cannot be used in the phase of depression that is when the price of goods and services are falling while the supply of money is constant and the quantity of such goods and services is falling. In such a period, the price levels cannot be revived by increasing the quantity of money in the economy.
  • The Policy Involves Contradictions and as Result of Which Seems Impracticable: The concept and purpose are contradictory and impracticable to each other. The concept is based on laissez-faire philosophy which is designed around assuming perfect competition in a free economy. This philosophy has become obsolete in the modern economy.

Opposition to Neutrality of Money

  • The neutrality of the money concept has received numerous criticisms. Critics who oppose this theory suggest that the nature of money is such that it can’t be neutral. When money supply goes up, its value goes down and when the supply of money rises, it enables its initial receivers to purchase such products and services that have minimal or zero change in price. This means that the ones who are receiving money lately will be bound to pay higher and unjust prices.
  • This is better known as the Cantillon effect. an increase in the supply of money can also impact production and consumption. When new money is introduced into an economy, it will cause prices to change which means that if the prices of goods and services are increased, then how to impact the same will have on individuals and families. This rise in the money supply can also increase associated costs entities as the production of goods and services will become a more costly affair.

Importance

The concept of neutrality of money puts forth the fact that the money has no real impact on an economy’s equilibrium since it is neutral in nature. As per the theory, the supply of money can change the prices of goods and services but it does not have sufficient power to alter the nature of the economy all by itself. It is developed from classical economics and still has less relevance in the modern economy. The theory has received huge flak for it doesn’t at all resonate with the current economy requirements. This theory is probably useful in the long term and not in the short term.

Conclusion

The concept of money neutrality suggests that any increase in the supply of money can change only the wages, prices and exchange rates (nominal variables) and not the economy as a whole. This concept fails to check the occurrence of fluctuations in the business in the modern economy.

Critics believe that this concept is impracticable since given the nature of money; it isn’t and can never gain a neutral status. An increase in the supply of money can affect consumption and production and when new money is injected into the economy, it has a huge change in relative prices.

This has been a guide to what is neutrality of money. Here we discuss the 2 types (Nominal Variables and Real Variables) of neutrality of money and how does it work along with importance and criticism. You can more about finance from the following articles –

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