Laura Kielek
Dr. Kassens
Econ 122
8 April 2014
The neutrality of money is
described as when the money supply only impacts nominal variables. This
includes prices, nominal GDP that measures the dollar value of the economy’s
output of goods and services, and wages and exchange rates. This means money
supply would have no affect on unemployment levels or real prices, which are
labeled as real variables (“Neutrality of Money”, 2014).
Nominal variables are measured in
monetary units instead of physical units, which are real variables. The
separation of these two variables is defined as classical dichotomy, and this
classical analysis states that nominal variables are influenced by developments
in the economy’s monetary system, and money is not valid to explain real
variables (Mankiw, 2012, p. 353).
Changes in the supply of money only
affect nominal variables, price levels, dollar wages, and all other dollar
values are changeable, but not the real variables including production,
employment, real wages, and real interest rates. This described the term, monetary
neutrality, and it is also defined as the irrelevance of monetary changes for
real variables. Most economists believe that monetary changes affect real
variables in the short run (within one or two years). Although, monetary
changes do have powerful effects on nominal variables in the long run, but only
slight effects on real variables (Mankiw, 2012, p. 354).
The Federal Reserve controls the supply
of money in our economy, which is the quantity of money that is made available
in the economy. Monetary policy is said to be decisions by policymakers
concerning the money supply (Mankiw, 2012, p. 330).
Central banks oversee the money
supply and have control to change the money supply when it is necessary ("Neutrality of Money", 2014). The Fed can change the money supply by changing the quantity of reserves. This
change is done by either buying or selling bonds in open-market operations, or
it is done by making loans to banks. In open-market operations, the Fed buys or sells government bonds. This can be
done very easily and it is used to change the money supply by a small or a
large amount without having to worry about the law or bank regulations. Also,
the Fed can change the money supply by changing the discount rate, which is the
interest rate on the loans that the Fed makes to banks (Mankiw, 2012, p. 337).
Monetary policy is useful when in
the presence of money neutrality because the decisions that are made to affect
the money supply are in order to prevent inflation, debt, and have a stable
economy with a level GDP. Since only nominal variables are affected with the
neutrality of money, the central banks and the Fed must be attentive when
changing the money supply.
References
(2014). Neutrality of money. Investopedia US, A Division of IAC.
Mankiw, N.G. (2012). Principles
of macroeconomics (6th ed.). Mason, OH: South-Western Cengage Learning.
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