Monetary Policy and Neutrality

Brandon Mayer

April 8, 2014

Econ 122

Dr. Kassens

The concept of the neutrality of money is based within the classical dichotomy, or the separation between real and nominal variables (Mankiw, 2012, 353). Essentially, application of this classical dichotomy demonstrates that changes in the money supply will affect nominal variables in the long-run, but these changes are not reflected in real variables. The unaffected nature of real variables in the long-run in relation to changes in the monetary supply is termed the neutrality of money. This principle of monetary neutrality is shown in the traditional view regarding the effects of monetary policy.

Historically, it was imagined that if there were a given monetary policy that would unexpectedly and permanently increase the money supply, then the effects of this increase would ultimately be neutral, or would not affect real variables in the long-run. Certainly, nominal variables would change and even real variables would shift value in the short-run, but ultimately the real variables would return to their original values (Bullard, 1999, 57). Bullard (1999,58) also gives a slightly alternative example in which a given policy adjusts the original money supply growth rate (already determined by a central bank) rather than a change the money supply directly, with the long-term unaffected nature of real variables in this case being termed monetary super neutrality. In both cases, this long-term effect, or lack of effect rather, on real variables is what is meant by the neutral effect of monetary policy.

If the effects of monetary policy are neutral in regard to long-run real variables such as labor ratio, real output, real consumption expenditures, and real interest rates, then what are the uses of such policies? The answer is that monetary policies can increase output in the short-run, even to the point of reversing the effects of a recession in a shorter period of time than if economic recovery were left to its own natural devices (Zimmermann, 2003, 63). This is the case because in the short-run, an increase in the nominal money supply results in a decreased nominal interest rate and, resultantly, a decrease in the real interest rate.  Along with a decreased real interest rate, aggregate demand and demand for individual goods increases. When suppliers meet this demand, output increases assuming that there are relatively inflexible prices in the short-run. Without the boost provided by the instituted monetary policy, output would likely return to its original level around the time of the medium or long-run. However, the policy boost assists in more quickly returning output to its pre-recession level by increasing output in the short-run and effectively shortening the recovery time. However, such boosts are not without costs, as we know that there is a short-term tradeoff between inflation and unemployment, with inflation being the cost of increased output in this particular example.

In regards to inflation, a central bank’s monetary policy that establishes a consistent growth rate for the money supply contributes to economic foreseeability and stability. This is due to the well-known Fisher Effect, which is a one-for-one adjustment of the nominal interest rate to the inflation rate, leaving real interest rates unchanged in the long-run, i.e. the idea of neutrality (Mankiw, 2012, 359). How is this monetary policy useful? Businesses, especially banks making loans, count on stability and predictability for making decisions regarding their individual growth plans, which in turn impacts overall economic growth. Thus, a central bank can continue to increase money supply at a consistent and predictable level while leaving real interest rates at basically a fixed amount. Therefore, both lenders and debtors can make investment and business decisions based on calculations with a predictable amount, improving confidence and growth in the economy via foreseeability.

References

Bullard, J. (1999). Testing Long-Run Monetary Neutrality Positions: Lessons from the Recent    Research. Retrieved from http://research.stlouisfed.org/publications/review/99/11/9911jb.pdf

Mankiw, N. G. (2012). Principles of Macroeconomics (6^th ed.). South-Western Cengage Learning.

Zimmermann, G. (2003). Optimal Monetary Policy: A New Keynesian View. The Quarterly Journal of
       Austrian Economics, 6(4), 61–72. https://mises.org/journals/qjae/pdf/qjae6_4_5.pdf