The Neutrality of Money

     The idea that money is neutral is an important one when discussing the US economy and economic policies. The neutrality of money can be understood once one understands the concept and function of the money "market". Once this basic understanding is established one can discuss the effects of an increase in the money supply, inflation, and interest rates on important economic indicators.

     The key to understanding the neutrality of money is understanding what the money "market" is and what its effect is on other aspects of the economy. The money market is essentially the conditions for investment in an economy. The supply side of the market is comprised of those people who deposit their money in banks, which then loan that money out. The demand side of the market consists of those people who take loans from the banks in order to invest. The factor that determines  money supply and money demand is the interest rate. If the interest rate is high more money will be saved in the banks but less money will be demanded by investors. Conversely if the interest rate is low investors will demand large loans but savers will deposit less money in the banks. The amount of loanable funds is important because it is connected to the growth rate of the RGDP. The Monetary Transmission Mechanism demonstrates that an increase in the money supply leads to an increase in loanable funds, which in turn leads to greater investment and therefore a higher RGDP.

     The neutrality of money means that increases or decreases in the money supply have no long term effect on real economic indicators such as GDP or the interest rate. The Quantity Theory of Money states that the larger the amount of money available the lower its value. This leads to Quantity Equation which states MV=PY where M is the money supply, V is the velocity of money, P is the price level and Y is RGDP.  Using this equation one can conclude that money is neutral. The velocity of money is the measure of how quickly money changes hands and is assumed to be stable and therefore constant. Because RGDP is a measure of the total production of a nation PY is the nominal GDP. Assuming that V is constant the Quantity Equation becomes M=PY, meaning that if the money supply increases then nominal GDP increases but because nothing new is being produced this increase is due to an increase in the price level. This relationship therefore demonstrates that inflation (increases in the money supply) only affects nominal values and not real ones.

     Money neutrality can also demonstrated without the Quantity Equation by exploring the definitions of NDGP, and RGDP. GDP is a measure of the market value of all the goods produced in an economy. RGDP is a measure of the value of all goods produced in an economy while holding price constant, meaning that RDGP is essentially a count of all the goods produced in an economy. NDGP is the same as RGDP except that it takes prices into account. Because RDGP is not influenced by price changes inflation cannot change a RDGP value, while potentially drastically altering a NGDP value.

     Money neutrality shows that changes in the money supply and inflation rates have no effect on real economic variables such as RGDP or the real interest rate. This is demonstrated through the Quantity Theory of Money and the Quantity Equation.