Money Neutrality

Tyler Martinez

April 8, 2014

Kassens

Macroeconomics 122

            When asked, “How is money neutral,” I recently read a definition from a website that states it is “An economic theory that states that changes in the aggregate money supply only affect nominal variables, rather than real variables.” (Investopedia, 2014).  Neutrality of money is said to be extremely related to classical dichotomy: the theoretical separation of nominal and real values.    

According to Professor Patinkin money will only be neutral if there is perfect wage, no money illusion, no distribution effects, no concerning interest rates, and no inside and outside money.  Inside money are things such as securities and bonds, while outside money is things such as foreign exchange and gold.  In other words, this is saying that if money supply increases during a long period of time, then price and job will rise, but this would have no effect on gross domestic product (GDP), unemployment levels, or prices in the real world.  For example, the price of one cd is $15 and the price of one pizza is $10.  If we are looking at relative price, 15/10 = 1.5… or 1.5 pizzas per cd.  If the central bank doubles the money supply making the cd $30 and the pizza $20, the relative price, or real variable is not affected. (30/20 = 1.5)         

            This theory also implies that the central bank does not affect our economy when makes currency.  The problem with the theory of money neutrality is that it is said to only work with long periods of time; for short periods of time, it DOES affect GDP, unemployment levels, and prices in the real world.  Although the theory is said to only work in long periods of time, it may also work during short periods of time as well.  Yes, when supply of money changes in a short period, it does affect nominal variables, but the “stickiness” of prices and wages can override these outcomes.  Prices and wages are said to be sticky because it is easier to increase prices and wages, but it is difficult to decrease prices and wages; for example, it is hard to get an employee to accept a pay cut.  Therefore, a modification in money supply does not affect the economy in the long run developing an economic equilibrium…or the neutrality of money.  

References

Neutrality Of Money In Classical Model | Economics Exposed. (n.d.). Retrieved from http://economics-exposed.com/neutrality-of-money-in-classical-model/

Neutrality Of Money Definition | Investopedia. (n.d.). Retrieved from http://www.investopedia.com/terms/n/neutrality_of_money.asp