Monetary Policy in the Presence of Neutrality

Rob Lentine

April 8, 2014

Macroeconomics 122

Dr. Kassens

            The theory of monetary neutrality is based around “the preposition that changes in the money supply do not affect real variables” (Mankiw, 2012, Ch.17).  Well, one might ask: What is meant by real variables?  Well, for instance, if the money supply was doubled, then the nominal prices of goods would double but the real prices or the price of something relative to other goods would not change.  The real price of something would not change when measured against the price of it during a base year or base index (Neutrality, Investopedia).

            The separation of nominal and real variables is known as classical dichotomy.  Classical dichotomy is what is behind the idea of monetary neutrality as it is what proposes the idea that nominal variables can be affected without real variables being affected (Mankiw, 2012, Ch. 17).  It is believed that this is only true, however, in the short run.  Economists agree that, in the short run, changes in the money supply can alter real economic variables like GDP and employment levels. 

            Of course we want our country to have high employment levels, a healthy GDP, and a steady economy and so this is where monetary policies come into play.  Monetary policies are put into place by a central bank, in our case the Federal Reserve (fed), to control the economy (Monetary Policy, Investopedia).  Their job is to maintain a steady and healthy economy and prevent excessive inflation.  The Fed has three main ways in which they can influence bank reserves and, in turn, the money supply: 1) Open-Market Operations, 2) Discount Rate Adjustment, and 3) Reserve Requirement Adjustment.  Open-Market Operations are, as I mentioned earlier, the purchase and sale of bonds by the Fed.  Secondly, the Fed can adjust the discount rate or the interest rate on loans the Fed makes to banks, to influence the amount of reserves the banks borrow.  The more money that the banks choose to borrow, the more money they will have for funding loans and increasing the money supply.  Lastly, they can do control the money supply by setting reserve requirements for banks, which requires a bank to withhold a certain percentage of a person’s deposit.  If the Fed sets a high reserve requirement then the money supply decreases because more money is held in banks and not available for loans (Mankiw, 2012, Ch. 16).  

            As you can see, in an economy based off of fiat currency, the Fed and monetary policies play an essential role in maintaining a healthy economy.  Their constant watch is necessary to regulate the economy especially in the presence of neutrality in this ever-changing world.

References:

Mankiw, Gregory. (2012). Principles of Macroeconomics: Sixth Edition. Chapters 16 and 17. Mason, OH. South-Western Cengage Learning.

Monetary Policy.  Investopedia Online. Retrieved from: http://www.investopedia.com/terms/m/monetarypolicy.asp

Neutrality of Money. Investopedia Online. Retrieved from: http://www.investopedia.com/terms/n/neutrality_of_money.asp