Jeremy Peavey
8 April 2014
Why
is Monetary Neutrality Important for Policy?
In
the 18th century, David Hume and his colleagues proposed the idea of
classical dichotomy by dividing economic variables into either nominal or real categories. Nominal variables are measured by monetary
units, whereas real variables are measured by physical units. Monetary neutrality proposes that a change in
money supply will only affect nominal variables and not real variables. This is useful for monetary policy, because
the presence of neutrality allows for analysis of different forces that
individually influence either nominal variable or real variables, but not
both. Typically, development in the
economy’s monetary system has a large influence on nominal variables, but is
irrelevant when explaining real variables.
For example, tripling the money supply also triples the price level, the
wage prices, and all other prices. Real
variables are unchanged: production, employment, real wages, and real interest
rate (Mankiw, 2012, p.354-355).
Monetary
neutrality is not completely realistic.
In the short-run monetary changes are expected to affect real variables
because the changes could lead to mal-investment. But, the classical dichotomy and neutrality
of money apply in the long-run to economic policy. Neutrality of money allows for economists to
study long-run changes in the economy to better understand how these processes
function. Over the past decade, monetary
changes have been shown to have a significant influence on nominal variables,
and very little to no influence on real variables (Mankiw, 2012, p.355).
An
important application of the principle of monetary neutrality is noticeable
when observing the effect of money on interest rate. According to monetary neutrality, an increase
in money supply results in increases in inflation rate but has no effect on
real variables. It is important to
understand the connection between these three variables. Nominal interest rate tells how fast money in
an account will accrue. Real interest
rate corrects for inflation and tells how fast savings’ purchasing power will
rise over time. Separating nominal
interest rate from real interest rate is important because there are different
economic forces that drive each of these variables. Supply and demand of loanable funds
determines real interest rate, and growth in the money supply determines
inflation rate. Understanding the Fisher
effect, a way to adjust nominal interest rate in terms of inflation rate to
determine real interest rate, is useful for monetary policy-making. The Fisher effect is most useful for monetary
policy-making by understanding changes over time for nominal interest
rate. There is a strong correlation
between nominal interest rate and inflation rate.
Economic
policy-making, as a way to stabilize the economy, requires an understanding of
the monetary neutrality and how this effects inflation and interest rates. Even if not all policy-makers agree with
neutrality of money, it is still important for them to understand the concept
and how it could apply in the long-run (Mankiw, 2012, p.355-356).
Sources
Mankiw,
N. G. (2012). Principles of macroeconomics . (Sixth ed.). Mason, OH: South-Western
Cengage Learning.
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