Simone Assaley

Kassens

Macroeconomics

April 8, 2014

Neutral Money and Monetary Policy

The monetary system we use today can be defined as fiat money, which has intrinsic value.  The reason for using this sort of structure is that it puts all goods and services in the same classification.  Because of this, the government tracks the expansion or regression of the country’s selling of goods and services.  The form of following the nation’s progress can be found in real and nominal variables.  Real variables are in the form of real GDP, real interest rate, and real wage, and nominal variables are nominal GDP, nominal interest rate, and nominal wage.  All of these variables help the country track the advancement of the nation.

            Monetary policy is the setting of the money supply by policymakers in the central bank (Mankiw 2012).  The central bank looks at the rates of change, and depending on whether they think that the nation is heading for inflation or recession, the central bank increases or decreases the amount of money put into the system.  There could be concern among the population that since the money supply changes that the ways of tracking the nation’s progress could be affected.  The idea of monetary neutrality is the proposition that “changes in the money supply do not affect real variables” (Mankiw 2012).  So the real variables like real GDP, real interest rate, and real wage are said to not be affected by policymakers changing the money supply.

            Money is neutral because of the classical dichotomy.  The classical dichotomy is the “theoretical separation of nominal and real values” (Mankiw 2012).  Since real and nominal values are said to be separated, monetary policy is said to affect the nominal values and variables, but not the real since real is relative.  Real values and variables are found by using a base year, and therefore are not affected by the amount of money in the system.  If the prices of goods go up, one good can be related to another in order to find its relative price.  If the price of chairs is $10 and tables are $20, then for every table two chairs can be purchased.  Later, the prices of everything doubles making chairs $20 and tables $40.  The relative price would still be 2 chairs for every table, which is what real variables measure.

            Since monetary policy does not interfere with the tracking of real variables, policymakers can change the money supply as they see fit.  Money neutrality helps for the nation to see where the country is progressing and regressing in terms of years past.  Since real variables are relative, they are not affected by the changes in money supply, and country is free to track improvement accurately and make sure that the country is always thriving.

References

Mankiw, Gregory. (2012). Principles of Macroeconomics: Sixth Edition.  Mason, OH. South-

            Western Cengage Learning.