Neutrality of Money

Ryan Raphael

Macroeconomics

Blog post #1

Monetary Policy and the Neutrality of Money

            Money is considered to be neutral when the effects of a change in nominal money supply are not felt by real variables. Real variables are measured in physical units, and include real GDP and real wage.  Real GDP is the value of output using the prices from a base year, and it is corrected for inflation. Nominal money is considered to be money that is measured in monetary units, instead of physical units. This includes nominal GDP, and nominal interest rate (rate of return measured in dollars). If money is neutral then when the FED implements monetary policy such as open market operations to increase the money supply, then the nominal prices will increase proportionally. Nominal GDP is the value of output using current prices not adjusted for inflation. However, this will have no effect on relative prices, they will remain constant. Since the real wage is also not affected, labor remains unchanged. The quantity of labor demanded and supplied does not change if money is neutral. In the short run, money has an effect on real variables.

      The central banks control the money supply through open market operations, which lead to short term changes. These short term changes do not effect real economic variables.  The model of aggregate supply and demand is used to demonstrate this effect. If the price rises in the short term, buying goods and services will require more money. It will also temporarily reduce the real GDP and quantity of output. The neutrality of money is based on the concept that the change in the money supply will not change the aggregate supply and demand of goods and services.

      The central banks also determine the inflation rate because they control the money. When they print too much money, prices rise and the value of the currency decreases. Inflation increases proportionally with nominal interest rate. This is referred to as the Fisher Effect. Monetary policy is helpful in the presence of neutrality because policy makers can adjust these interest rates and control the money supply. One of the ways they control the money supply is by determining the amount of money banks need to keep in their vault, also called bank reserves. When banks are forced to keep more money in their vaults, they have less money to make loans with. Increasing this reserve rate decreases the amount of money the banks could have.

 

 

Bibliography

Mankiw, N. G. (2012). Principles of microeconomics (6th ed.). Mason, OH: South-Western Cengage

       Learning.

Neutrality of money. (n.d.). Retrieved from

       http://www.investopedia.com/terms/n/neutrality_of_money.asp

Monetary policy. (n.d.). Retrieved from

       http://www.investopedia.com/terms/m/monetarypolicy.asp