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Economics Terms A-Z

Monetary Neutrality

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By , reviewed by Tom McKenzie

Monetary neutrality is an economic theory that states money and the money supply do not affect any real economic variables, only nominal ones. This theory was initially popularized by classical economists, and though it has received challenges from Keynesian and monetarist ideas, it remains an important theory in the field.

Money serves several important functions in the economy. It is a unit of account, which allows people to view the cost of goods in comparable terms. It is a store of value, allowing people to store up the value of their labor over time, i.e. saving to grow their wealth. It is also a medium of exchange, allowing people to trade goods for just money rather than being forced to barter. The article money and the money supply dives further into these useful qualities of money.

Directly following from these qualities is the fact that money forms the basis of prices in the economy. Prices are quite useful as they are directly comparable numbers that tell economic agents how much a good or service costs in nominal terms.

Money affects nominal values only

In economics, real variables measure actual economic output that occurs in the real world. For example, if a candlemaker produces three candles, the value of those three candles would be included in the count of real GDP. Meanwhile, nominal variables are those – such as prices – that are not exact or direct measurements of real economic value, but approximations.

In short, nominal values measure the price of a good or service, which is meaningless without knowing the prices of other goods in the economy. Real values are meaningful and allow for direct comparison, because they are relative values compared to other real goods and services.

When considering the economy as a whole, using real values allows for meaningful comparison of various countries’ GDPs to one another and across different years, for example. With real values, we can directly compare if the Bolivian economy was more productive in 2022 or 2023.

Monetary neutrality states that money only affects nominal values, but not any real values in the economy. Therefore, because economic agents are rational and make decisions based on real values, money essentially doesn’t affect the economy at all.

Recall that classical economic theory also states that price changes are spread instantaneously throughout the economy, and recognized by everyone. This means that when prices in the economy change, the only effect is to change prices throughout the economy – real values, including the decisions of economic agents, are unaffected. In other words, the real, relative values of goods and services are unchanged. Thus, changing the supply of money – which would change prices – doesn’t affect the economy.

The philosophy behind monetary neutrality

If this seems ludicrous, consider the following. Let’s say that our friend the candlemaker produces and sells candles for $2.50 each in the year 1995. The candlemaker wants to buy a liter of milk on the way home from work one day, which costs $7.50. In order to purchase this liter, then, he must sell 3 candles that day.

Then, prices across the economy suddenly double, so that the candles now sell for $5 (suppose that nobody is holding any cash in this economy). Is the candle worth twice as much as before?

The answer is clearly no. If all prices have doubled in the economy, the candle is still worth the same compared to every other good in the economy. The candlemaker must still sell three candles (now at $5 each) in order to purchase the same liter of milk, which now costs $15. Effectively nothing has changed.

The previous example shows that prices are essentially just arbitrary numbers. Although they do communicate information to consumers, they are only meaningful in the context of the rest of the economy. If we double them, triple them, or reduce them by a factor of 100, nothing happens – as long as we do the same for all other price values.

Prices are one thing. But how does doubling prices in the previous example show that money is neutral?

Money, of course, is closely related to the price level in the economy. Ceteris paribus, if there is more money in the economy, prices will be higher. This is because more money is chasing the same amount of real goods and services that have been produced. This is also a key reason why increasing the money supply can often lead to inflation.

Monetary neutrality as told by the Big Mac Index

A great way to illustrate monetary neutrality is by using the Big Mac Index. This index compares the prices of the McDonald’s Big Mac sandwich around the world (view the latest Index values here), and as such is normally used to examine which currencies are over- or under-valued compared to one another, or to introduce concepts like Purchasing Power Parity. It was initially published by the Economist in 1986 as a fun way to compare prices across countries, but it has taken off and remained part of our economic discourse ever since.

As of this article’s publishing, in Mexico, a Big Mac costs about 85 pesos. In the US, meanwhile, it is roughly $5.58. But, according to the Index, both the US and Mexico share a Big Mac price of 5.58 US dollars. This means that the Big Mac is worth the same in both countries, even though the prices, money supplies, velocity of money, and monetary policies are completely different in each local market. In other words, the same real good is worth the same amount regardless of the differences in the amount of money in each economy.

Of course, examining the Big Mac Index shows varying values for different countries. This can be due to several factors. The availability and cost of alternatives in different local markets, the usage of different ingredients, cultural factors, and the existence of different taxes in different countries could all contribute to different prices for a Big Mac to the end consumer in different places. Nevertheless, the Index shows how monetary neutrality could work across very different markets; Big Macs sold in many countries that have different currencies (and different money supplies) may still cost the same in real terms.

Comparing prices across countries doesn’t need to be left to the Big Mac Index, thankfully. Economists typically use Purchasing Power Parity and currency exchange rates to compare prices.

Examining monetary neutrality through MV = PY

Despite the example with the candlemaker, money and prices are not perfectly linked. If the amount of transactions in the economy increases in any given period of time, prices will be increased as well, even if the money supply doesn’t change. This is because the price level (represented by the price level, P, times output Y) is equal to the amount of money held in the economy M times the velocity of circulation V. This gives us the equation MV = PY.

Studying this equation reveals a few things. First, if the money supply M or the amount of transactions occurring V increases, output Y might not change at all. If the price level P simply rises (or falls) in proportion with increases (or decreases) in M and V, output will be unchanged. This is precisely what monetary neutrality states; any changes in M and V will be perfectly offset by changes in P, leaving Y unchanged.

In the short run, money probably does matter…

Although there are perfectly fine arguments to suggest that money is neutral, it’s quite difficult to believe that money is always neutral in our modern economy. First of all, the classical theory of money neutrality rests on a few assumptions that are difficult to believe: first, that prices adjust immediately across the whole economy, and second that economic agents always have full information about prices to make rational decisions.

After all, wages – the price for labor, a very important factor of production – are often set by legal agreements and cannot be changed quickly (this idea is known as “sticky wages” in economics). Further, when increases in the money supply cause inflation, people feel worse off as the purchasing power of their money is reduced. Likewise, when the government needs to pay off its debts, it might try to print money in order to do so (which can cause hyperinflation if they’re not careful).

Most economists have come to agree that money probably does affect real economic variables in the short run. Increased prices for goods (like from an upward shift of the aggregate demand curve) incentivize producers to make more of those goods in the short run to take advantage of the temporarily increased profitability, moving equilibrium up the short-run aggregate supply curve. This increased production may reduce the unemployment rate and increase production (as measured by GDP, for example). Classical economists have adopted these ideas into updated theories, eventually giving rise to the “neoclassical” school of economic thought.

…but in the long run, monetary neutrality generally holds

This doesn’t mean that monetary neutrality is an outdated and useless theory, though. In the long term, most economists agree that prices are considered “fully flexible”. Time allows wages to be renegotiated, and other prices across the economy to be updated. Further, it allows economic agents to get used to the new prices.

Therefore, in the long run, changes in the supply of money (or the velocity of money) eventually do nothing except change the price level. This causes only nominal values to change, and has no effects on real values. Most current macroeconomic models include this idea of long-term monetary neutrality.

Going further, it makes sense that the amount of money in the economy does not affect the function of the economy in long run equilibrium. The productivity of labor, availability of natural resources, the contributions of human capital, and more are all unaffected by money in the long run. Having more paper slips used for cash doesn’t make people smarter and doesn’t make crops grow more. In other words, money does not directly improve or cause any real economic factors that grow the economy. Therefore, in the long run, it is neutral.

Good to Know

The idea of monetary neutrality in the short run suggests that printing money, or changing the money supply in other ways, is completely ineffective. The economy will instantly adjust to any changes in the money supply, causing the short-run aggregate supply curve to be vertical.

This means that, from a classical economics perspective, monetary policy conducted by the central bank is essentially useless. Therefore, classical economists might argue against having a central bank conduct any monetary policy at all!

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