What Is 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. At the same time, overall economic productivity remains unaffected, or in other words, monetary supply has sufficient power to affect the cost of goods and services. Still, it doesn’t have any impact on the overall economy.
It is a concept of classical economics. However, 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 productivity nor increase the country’s GDP (gross domestic product).
Table of contents
- The neutrality of money refers to the concept that the money supply has the power to impact the goods and services in an economy but still not affect the entire economy.
- Two types of variables affect the neutrality of money: Real variables (wages, prices, etc.) and Nominal variables (real output, employment rate, etc.)
- Economists argue that money neutrality is an outdated concept with little to no relevance in the current world. It involves no guarantee for price stability, doesn’t work during recessions, and seems impractical.
- Superneutrality of money refers to the long-term impact of changes in the money supply on the economy. It is a heavier concept, stating that the prices and nominal wages remain proportional to the money supply.
How Does The Neutrality Of Money Work?
The concept of long run neutrality of money 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. However, this concept fails to check the occurrence of fluctuations in the business in the modern economy.
Critics believe that this concept is impracticable since it isn’t and can never gain a neutral status given the nature of money. 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.
Money can either be used for saving or spending purposes. The new money injected into the economy will tend to be deposited in the bank accounts, and some 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 same demands. The increased demand might also boost employment as the employers will urge to hire more employees, and the need for employees will ultimately allow a rise in the wages.
It is of two types of long run neutrality of money–
- Nominal Variables: Wages, prices and exchange rates are fine examples of nominal variables.
- Real Variables: Output (Gross Domestic Product), employment, and the amount of real investment are fine examples of real variables.
Let us understand the concept with the ehelp of an example.
Let us assume that there is an economy where certain goods and service are produced and people have an income enough to buy them. But suddenly the policy makers decide to increase the money supply in the economy through fall in interest rates. The people now have more money in their hands and they can take loans to buy goods and services of their choice because loans have become very cheap now. However, it is to be noted that along with demand, the prices will also increase in the long run.
So here we see that in the short run, people think that they are rick because they now have more money in their hand and are able to afford more. But in the long run, as prices rise with demand, their purchasing power returns to the same level. Thus, the increase in money supply does not disturn the economic balance in any way. This is neutrality of money.
Some importance of the concept of neutrality of money macroeconomics are as follows:
- The concept puts a certain degree of predictability regarding its effect on the economy. This helps in anticipating the changes that may happen if money had unpredictable changes.
- The concept of neutrality of money puts forth the fact that money has no real impact on an economy’s equilibrium since it is neutral. 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 as it doesn’t resonate with the current economic requirements. This theory is probably useful in the long term and not in the short term.
- Neutrality of money macroeconomics helps business take planned economic and investment decision for long term. Therefore, the neutrality concept makes planning less challenging.
- This also helps in maintaining a stability in prices with the implementation of monetary policy.
- It also helps the central banks of the country to be confident and have clarity with implementing monetary policy since their actions does not cause any disruption in the economy but helps in maintaining steady prices and a stable economy. The concept lead to some rationality in the expectation of consumers from the application of various economic models. If money would not be neutral, this would create a problem in implementing the various models of economics.
Now let us study the criticisms of the concept of expectations and the neutrality of money in details.
- Outdated Concept: Economists criticize the concept of money neutrality because it is based on the quantity theory of money, which is an outdated concept. Economists discarded 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 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-faireLaissez-faireLaissez-Faire refers to an economic doctrine advocating minimum or no interference from the government in business and economic affairs. philosophy designed around assuming perfect competitionPerfect CompetitionPerfect competition is a market in which there are a large number of buyers and sellers, all of whom initiate the buying and selling mechanism. Furthermore, no restrictions apply in such markets, and there is no direct competition. It is assumed that all of the sellers sell identical or homogenous products. in a free economy. This philosophy has become obsolete in the modern economy.
- The expectations and the neutrality of 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 the initial receivers to purchase products and services with minimal or zero change in price. This means that those 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 causes prices to change, which means that if the prices of goods and services are increased, it will impact individuals and families. This rise in the money supply can also increase associated costs as goods and services will become a more costly affair.
Neutrality Of Money Vs Superneutrality Of Money
The neutrality of money and the superneutrality of money are used for designing long-term models for an economy.
- Superneutrality of money is a stronger concept than the 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 money neutrality, the concept of not superneutrality of money states that the prices and nominal wages remain proportional to money supply during one-time changes in the nominal supply of money and permanent changes concerning the growth rate nominal supply of money.
Frequently Asked Questions (FAQs)
When a one-time adjustment in either the money supply or the money demand has no discernible impact, money is said to be neutral. However, money is also not neutral when supply or demand changes have noticeable consequences.
Money is considered neutral in the classical model approach. There is no impact on the real variables—actual quantities and relative prices—when the money supply increases; instead, it raises the overall price level by the same amount.
The neutrality of money theory was later developed from David Hume’s (1711–1776) discovery of the neutrality of money in the 18th century.
This has been a guide to what is neutrality of money. We explain types, examples, importance, criticisms & differences with superneutrality of money. You can more about finance from the following articles –