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Neutrality of Money
1. Introduction
📌 The Neutrality of Money is a fundamental concept in classical and monetarist economics, stating that changes in the money supply affect only nominal variables (prices, wages) but not real variables (output, employment) in the long run.
🚀 Why is it important?
✔ Helps explain inflation and monetary policy effects.
✔ Forms the basis for the Quantity Theory of Money (QTM).
✔ Supports the idea that monetary policy should focus on price stability rather than influencing real economic growth.
2. Understanding the Neutrality of Money
🔹 1. Definition
✔ Money is neutral if changes in the money supply affect only nominal variables (like price level and wages) but leave real variables (like GDP, employment, and consumption) unchanged.
✔ Example: If the central bank doubles the money supply, prices and wages double, but real output remains the same.
🔹 2. Classical View: Long-Run Neutrality
✔ Classical economists (Hume, Ricardo, Mill) argued that money only determines price levels, not real economic activity.
✔ This is based on flexible prices and wages, which adjust instantly to changes in money supply.
🔹 3. Monetarist View: Friedman’s Interpretation
✔ Milton Friedman accepted long-run neutrality but argued that money has short-run effects on output and employment.
✔ In the short run, wages and prices are sticky, so money supply changes can influence real GDP and unemployment.
✔ However, in the long run, the economy adjusts, and money only affects prices.
🔹 4. Mathematical Representation: Quantity Equation MV=PYMV = PY
Where:
- MM = Money supply
- VV = Velocity of money
- PP = Price level
- YY = Real output (GDP)
✔ If MM increases and VV remains constant, PP must rise if YY is fixed, confirming long-run neutrality.
3. Policy Implications
🔹 1. Ineffectiveness of Monetary Policy in the Long Run
✔ Since money only affects prices in the long run, central banks cannot use monetary policy to boost long-term economic growth.
✔ Instead, they should focus on inflation control.
🔹 2. Short-Run Non-Neutrality
✔ In the short run, monetary expansion can lower interest rates, boost demand, and reduce unemployment.
✔ However, once prices adjust, the real effects disappear.
🔹 3. Hyperinflation and Money Supply
✔ When money supply grows too fast, it causes hyperinflation, reducing money’s purchasing power (e.g., Zimbabwe, Venezuela).
✔ This reinforces that money neutrality holds in the long run.
4. Criticisms of the Neutrality of Money
🔸 1. Keynesian View: Short-Run Effects Matter
✔ Keynesians argue that money is not neutral in the short run due to sticky wages and prices.
✔ Governments can use monetary policy to fight recessions.
🔸 2. Real Effects of Monetary Policy
✔ Some studies suggest that monetary policy can have lasting effects on employment and growth through investment and productivity changes.
🔸 3. Endogenous Money Theories
✔ Post-Keynesians argue that money supply responds to economic activity, meaning central banks cannot fully control it.
5. Conclusion
✔ Money is neutral in the long run, affecting only prices and wages.
✔ In the short run, monetary policy can influence real GDP and employment, but these effects fade over time.
✔ Central banks should focus on controlling inflation rather than trying to boost long-term growth.