The Neutrality of Money

Allison Baker
Dr. Kassens
Macroeconomics 122

In theory, money should be neutral, in the sense that any changes in the nominal prices of goods, won't affect the real prices of those goods. In this concept an increase in the money supply will cause increases in variables across the board, therefore keeping everything even or neutral. We base this principle on the laws of supply and demand, stating that although the nominal price of a good may rise, the value of the good and its relative price will both remain the same. Although this concept may, and most likely is true over the long term, its effects are less seen in the short term business cycles. One of the reasons for this is the inability for the market to respond immediately to changes in the market. There is an adjustment period that the market goes through in a response to any change introduced to it, and an increase in money supply is no different. 

One of the issues with the neutrality of money can be seen in mismanaged monetary policy are cases of hyperinflation. This occurs when general inflation moves over 50% per month because of a dramatic increase in the money supply, usually occurs when the government prints too much money. Cases of hyperinflation can be devastating on an economy and hard especially hard to recover from. In one example of hyperinflation that occurred in Germany post World War I, employees would get paid twice a day and go out and buy items right away because the currency would lose so much value in just a few hours. Another example that we talked about in class was in Zimbabwe where it would cost trillions of dollars just to buy a loaf of bread. In both these examples, uncertainty about the future of the economy caused people to spend, not save their money, so therefore there can be no new investment, and therefore no new growth.  Although no new economic growth can have severe backlashes, a loss of faith in the regulatory bodies of the government, and by extension the government itself can have harsh political consequences. In Germany, this political consequence was the rise of Hitler and the start of World War II. Zimbabwe’s political system already faced issues, but if the nation had been a relatively stable and open democracy, the consequences may have been worse. 

There are actions that policy makers can take to prevent dramatic increases in the money supply that cause issues like hyperinflation. Through taking steps to change the money supply through different market operations, the government can more easily control and stop any drastic changes to the money supply. The Federal Reserve, the central bank of the United States, does this through close monitoring of the money supply and the prices of goods through measures like Gross domestic products and the consumer price index. If they see issues the Fed can institute specific operations, like open market operations and slowing down the printing of money to adjust the current money supply.  

References

"Neutrality Of Money." Investopedia. N.p., n.d. Web. 08 Apr. 2014.  http://www.investopedia.com/terms/n/neutrality_of_money.asp