How is Money "Neutral"?

Patrick Daum

April 08, 2014

Blog Entry #1

How is Money "Neutral"?

Money being neutral, or having the property of neutrality, is a concept that is not often discussed in entry level economics circles, but does have interesting effects on how the effectiveness of the monetary system. According to Christensen, (2012) the neutrality of money is based around the thought process that an increase or a decrease in the supply of money effects only nominal values.  Nominal values which are in contrast to real values, are defined as values that have not been adjusted for long term changes in price (Mankiw, 2011). Examples of nominal values are things such as exchange rates, prices, and wages (Christensen, 2012). Prices and wages are two things that can be easily connected to the neutrality of money. In the long term there is a direct impact between the neutrality of money and the impact on nominal values. 

For example, if the Fed allows more money to be circulating in the economy, then businesses and consumers alike will possess an increased amount of money. Over time, this will lead to inflation in the costs of goods and services because consumers will have more money to spend and a greater demand for a wide variety of products. To balance this greater demand inflation will occur. The price of goods will rise until equilibrium in the market is met once again. 

The reverse effect of an increase in money supply is true. If the government decreases the amount of money in the economy, deflation will occur over a longer period of time. Typically the economy will not experience short term fluctuation on pricing and wages. It is not logical for the economy to have quickly fluctuating nominal values, but over a longer period of time it is common. This means that in the long term, government monetary policy can directly affect the neutrality of money in a way most commonly seen in money supply and it's effects on inflation. 

While the neutrality of money affects nominal values, it does not affect real values. Real values are those that have been adjusted for inflation such as real GDP and employment (Christensen, 2011). This idea is key in the scope of how money is neutral because it implies that the Fed  with its monetary policy does not have the ability to have total control of some key economic indicators of success. What offsets the Fed's monetary decision to increase/decrease the amount of money in the economy is inflation/deflation and its natural response to whatever policy the Fed chooses to employ. Real GDP, which is the total value of all goods and services produced in an economy in a year, will not be affected because it adjusts for inflation (Mankiw, 2011). Employment is also not affected because even with an increase in money in the economy businesses will not be left with a surplus of profits with which to hire. The decreasing the value of their individual dollars will see operating expenses grow for businesses as well as wages. 

This is the essence of  how money is "neutral". Some of the usefulness of monetary policy becomes negated because changes are offset by inflation. For this reason neutrality has little to no effect on the ultimate indicators of economic succeeds. 

Sources:
Christensen, L. (2012, October 13). “Money neutrality” – normative rather than positive. The Market Monetarist. Retrieved April 8, 2014, from http://marketmonetarist.com/2012/10/13/money-neutrality-normative-rather-than-positive/

Mankiw, G. (2011). Principles of Macroeconomics (6 ed.). Andover : South-Western College Pub.