Money Neutrality

What is Money Neutrality?

Money neutrality is a concept of monetary economics for which an increase in the supply of money affects only prices, without impacting the real economy.

In other words, according to money neutrality, an increase (decrease) in the money supply will determine an increase (decrease) in the price of goods and services sold, but not in the real amount of goods and services sold, real GDP, or unemployment.

Supply and Demand for Money

To understand money neutrality, we need to understand the relationship between supply and demand for money. As in any free market, supply and demand will meet each other at an equilibrium point at a certain price. For money, the price corresponds to the interest rate paid on the money borrowed. It means that:

• Given the money supply as a constant, the demand for money is a function of the interest rate charged.
• If the interest rate rises, the speculative demand for money falls.
• If the interest rate falls, the speculative demand for money rises.
• For any level of money supply, there is a level of interest rate for which no excess demand or supply exists.

The equilibrium point is usually referred to as the Equilibrium Interest Rate.

Actions of Economic Agents

• If the interest rate is above the equilibrium point, there is an excess supply of money. As a result, economic agents use the liquidity to buy bonds, pushing up their price until the interest rate is back to the equilibrium rate of interest.
• If the interest rate is below the equilibrium point, there is an excess demand for money. As a result, economic agents sell bonds, pushing down their prices until the interest rate is back to the equilibrium rate of interest.

Effects of an Excess Supply of Cash

As in any market, when the supply of a good rises more than demand, such good becomes less valuable, and its price declines. Similarly, when the supply of money increases, its price (the interest rate) declines.

While the theoretical models help, the effects of interest rates and monetary policy are not so simple.

When there is an increase in money supply, there is an excess supply of cash for businesses and people that they can use in several ways, such as:

• They can lend it to other businesses and individuals;
• They can use it for buying financial assets, such as bonds; and/or
• They can use it for buying real assets, goods, and services.

Real Economy and Money Neutrality

While the excess cash can be used to buy goods, services, assets, or for paying workers, the amount of money in circulation does not affect an economy’s capacity to produce goods and services, which rather depends on other factors, such as the availability of labor, natural resources, real assets, and factor productivity.

Changing the supply of cash does not change the availability of natural resources, real assets, or labor productivity. That’s why many economists believe that changing the money supply, at least in the long term, will only affect the prices of the goods and services sold, as a different amount of money will be spread over the same amount of goods and services.

Money Neutrality in the Real World

Some economists support the concept of money neutrality, while others disagree. In general, it can be agreed that policymakers don’t believe that changes in the money supply do not affect the real economy. If they did, monetary policy measures, such as cutting or raising interest rates, or quantitative easing/tightening, cannot be explained.

Policymakers generally believe that, at least in the short term, an increase (decrease) in money will result in a positive (negative) effect on economic activity.

Money Neutrality and Short-term Changes in Money Supply

While many economists defend money neutrality in the long term, the effects of money supply on the economy in the short term are difficult to ignore. For example, the excess liquidity created in the short term can exert an impact on the inflation rate. With inflation rising, holding money becomes less attractive than holding real assets. As a consequence:

• People will allocate their resources away from cash and into durable goods or even increase their consumption of non-durable goods. It will obviously lead to an increase in consumption and GDP and a decrease in inventory levels.
• Companies will allocate more resources into real assets, potentially increasing their productive capacity and actual production levels. As a result, industrial production and GDP growth will increase.

More Resources

CFI is the official provider of the Commercial Banking & Credit Analyst (CBCA)™ certification program, designed to transform anyone into a world-class financial analyst.

In order to help you become a world-class financial analyst and advance your career to your fullest potential, these additional resources will be very helpful:

• Capitalism
• Inflation
• Law of Diminishing Marginal Utility
• Nominal GDP
• See all economics resources