According to the notion of money’s neutrality, changes in the money supply only affect nominal variables like salaries, prices, and exchange rates and have no effect on real economic variables like employment, real GDP, and real consumption. The neutrality of money, a fundamental idea in classical economics, is linked to the classical problem. It implies that the real economy—that is, employment, GDP, and actual investment levels—is unaffected by the central bank’s production of money. Instead, any increase in the money supply would be offset by a commensurate rise in wages and prices. This idea is the foundation of a number of well-known macroeconomic models (e.g., real business cycle models). According to some, like monetarism, money is
The stronger quality is money’s advantage over neutrality. It contends that genuine economic factors are unaffected by the amount of money in circulation or its pace of increase. In this case, changes in the nominal money supply cause nominal wages and prices to respond proportionally, both to one-time, permanent changes in the money supply’s growth rate and to permanent changes in the money supply itself. Long-term models are typically used to explain super neutrality.
A number of economists claim that money neutrality accurately captures the long-term dynamics of the economy; but, in the near term, monetary-disequilibrium theory prevails, indicating that adjustments to the nominal money supply would have an effect on production. One rationale is that salaries in particular are not easily adjusted to reflect an unexpected change in the quantity of money in circulation because they are sticky owing to variables like menu pricing and other expenditures. The real reason why changes in the money supply have an influence on the economy might possibly be due to consumers not knowing that changing prices would benefit them. The bounded rationality approach states that because people would not have factored in small drops in the money supply when they sold their homes or looked for work, they would have searched for a completed contract for a longer time than they would have if there had been no monetary contraction. Additionally, it is observed that most companies have a floor on nominal wage adjustments of zero, which is an arbitrary figure in accordance with the theory of monetary neutrality but a psychological threshold brought about by the money illusion.
The neutrality of money has been a major problem for monetarism. The Phillips curve served as a framework for discussing the most noteworthy answers. Assuming adaptive expectations, Milton Friedman distinguished between a sequence of short-run and long-run Phillips curves. The natural rate of unemployment was represented by the long-run curve, which was a vertical line, and the traditional, negatively sloping short-run curves. Because changes in the money supply constantly trigger responses from economic agents who are duped by the money illusion, Friedman argued that money was not neutral in the short run. If the monetary authority chooses to enhance the money supply and, therefore, the price level, agents will perceive a nominal salary rise as real changes since they will never be able to distinguish between real and nominal changes. Additionally, this will enhance the labor supply. However, agents will quickly ascertain the actual circumstances, so this is really a stopgap solution. Since higher compensation correlated with growing prices, there was no actual change in revenue and no need to hire additional people. In the end, the economy will revert to its starting point after this little interruption.
The new classical macroeconomics of Robert E. Lucas also contains a Phillips curve. But the situation is far more complicated because these models presuppose realistic expectations, which makes things much more challenging. Lucas considered the islands model to be the general framework that made it possible to investigate the mechanics behind the Phillips curve. The original Lucasian island model (1972) attempted to offer a framework to enable the investigation of the nature of the relationship between inflation and real economic performance by presuming that no trade-off can be benefited from by economic policy. Lucas’s goal was to prove that the Phillips curve exists when there is nothing.
Since it has long been known that there is a trade-off between inflation and unemployment or actual economic performance, the existence of a short-term Phillips curve is undeniable (or there are short-run Phillips curves). Although there are fewer avenues for monetary policy to manipulate the labor market to increase supply, unexpected events might still result in real reforms. But what is the central bank’s ultimate purpose when it comes to changing the money supply? Consider the bulk of countercyclical control applications. Monetary policy would lessen the negative effects of a severe macroeconomic shock by expanding the money supply.
However, monetary policy is unable to benefit from the trade-off between inflation and actual economic performance since there is no previous knowledge of the shocks to be avoided. In these conditions, the central bank is unable to coordinate a countercyclical monetary policy. A well-known economic plan is completely useless since only abrupt alterations have the capacity to create reasonable agents. However, the central bank is unable to foresee unexpected actions ahead of time, and this is significant since it lacks an informational advantage over the agents. The central bank does not know what it should remove through countercyclical measures. Although there is a trade-off between inflation and unemployment, it cannot be used by monetary policy to achieve countercyclical objectives.
Since money is not neutral in the short run, the New Keynesian research program specifically stresses scenarios in which monetary policy may affect the real economy.
Post-Keynesian economics and monetary circuit theory, which stress the role that bank lending and credit play in the generation of bank money, reject the idea that money is neutral. The significance of nominal debt is also emphasized by post-Keynesians, who contend that although levels of nominal debt are often uncorrelated with inflation, deflation increases the real value of nominal debt and leads to real economic effects like debt deflation.
Reasons for separating oneself from super neutrality
Even if money is neutral, it can also be non-super neutral, which means that actual magnitudes are independent of the amount of money in circulation at any one moment. This is due to the possibility that the rate at which the money supply grows might affect actual variables. When the rate of inflation and monetary growth rise, the real return on money that is strictly defined (zero nominal interest bearing) falls. People choose to reallocate their asset holdings from money to real assets like stocks of products or even productive assets, which results in a drop in the demand for real money. variations in the money demand can affect the amount of loanable funds available, and variations in both the nominal and real interest rates can also have an impact on real interest rates. If verified, it might affect real expenditure on capital goods and durable consumer goods.
Conclusion
Money neutrality, a cornerstone of economics, investigates the relationship between changes in the money supply and their impacts on the economy. A thorough understanding of money’s neutrality allows policymakers, economists, and investors to make well-informed judgments on monetary policy, long-term growth prospects, and market efficiency. The theory is nonetheless an essential resource for comprehending and interpreting economic events, notwithstanding differences and objections.
