Neutrality of Money Theory: Definition, History, and Critique

A staple in classical economics, the neutrality of money theory suggests that changes in the supply of money within an economy only affect nominal economic variables such as exchange rates, wages, and the prices of goods and services. Changes in the money supply do not affect real economic variables, such as consumption, employment, and real gross domestic product (GDP).

That’s because 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.

Understanding the Neutrality of Money

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

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

On the other hand, a decrease in the money supply will cause only a decrease in the prices of goods and services, but not a decrease in the real amount of consumption, employment, and real GDP. Therefore, the theory implies that the central bank cannot affect the real variables within an economy only by controlling the money supply.

Equilibrium

The reasoning behind the theory is that any change in the money supply is counteracted by changes in the prices of goods and services and the wages that an individual earns. For example, in a well-functioning free market, goods and services clear at a level where supply and demand balance, called equilibrium.

Since an increase in the money supply affects only the nominal price of goods and services that the money can buy, it won’t change the underlying conditions in the economy — a basket of eggs may cost more, but the buyer also earns a commensurately higher wage.

The increase in supply doesn’t create more eggs or curtail the demand for eggs. The increased money supply also does not produce more egg farms or push innovation to build upon existing knowledge and skill.

Therefore, in real terms, the theory states that since believed changes in the money supply affect buyers and sellers of all goods and services proportionately and nearly simultaneously, the only thing that will change is the price of goods and services and not the amount of goods and services provided and consumed.

When neutrality of money and 0% population growth coincide, the economy is in steady-state equilibrium, according to the theory.

The History of Money Neutrality

Friedrich A. Hayek (F.A. Hayek), an Austrian-British economist, coined the term “neutrality of money” in his 1931 London School of Economics lectures on “Prices and Production.” However, some historians believe that the origin of the concept can be traced back to the 1700s to Scottish philosopher and economist David Hume.

When it was first used, the neutrality of money theory stated that changes in money supply cannot in any way affect economic output or employment. However, as opponents challenged the theory with arguments of short-run impacts such as price stickiness and business sentiment, this later changed to money being neutral in the long run.

However, there are some, most notably post-Keynesian economists, who reject money neutrality in both the short and long run, citing econometric studies that suggest that variations in the money supply affect relative prices over long periods of time. Keynes himself famously also rejected the neutrality of money in both the short term and the long term.

Neutrality of Money vs. Superneutrality of Money

Superneutrality takes the concept of money neutrality one step further. It posits that not only is the real economy not affected by changes in the money supply, but that the economy is also impervious to changes in the rate of money supply growth. Both the concepts of superneutrality and neutrality of money are used when looking at long-term models of the economy.

However, there is also an argument against the superneutrality of money theory, while conforming with the theory of neutrality of money. Even if money is neutral, the growth rate of the money supply could affect real variables. A rise in the growth rate of the money supply will result in rising inflation, which could lead to a decline in the real return of money.

Holding money becomes less attractive than holding real assets. Therefore, companies, investors, and savers will choose to reallocate their holdings away from money and into real assets such as houses, inventories, and risk assets.

This may change the amount of funds available to be lent and impact real interest rates, affecting consumption of say, durable consumer goods or capital expenditures by companies.

Opposition to the Neutrality of Money

Critics of the neutrality of money theory suggest that, by its very nature, money isn’t neutral. When the supply of money goes up, it causes a corresponding drop in its own value.

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. As a consequence:

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

Cantillon Effect

In addition, when the money supply rises, it enables those who recognize it first to essentially purchase goods and services with little to no change in price. As the new money trickles down to later users, prices will have gone up to counteract the surplus of money. This means that those receiving the money later will be forced to pay higher prices. This is known as the Cantillon Effect.

An increase in the money supply also affects consumption and production. New money injected into an economy causes a necessary change in relative prices, as discussed above. It means that everything costs more, so how much individuals and families consume will change. It also raises associated costs for companies, making production a more costly venture.

Stickiness of Prices

Another oft-quoted criticism of neutral-money economic theory is that prices, at least in the short run, are sticky. Think of the example of wage contracts. If the money supply increases, then according to the neutral money theory, the price of labor increases. However, in the real world, labor contracts are not continuously adjusted — any wage increase for workers might need to wait for the next fiscal year or contract renegotiation.

Another effect of increasing the price level is associated costs — for example, if you are running a restaurant. If the money supply were to increase, in theory, you would be able to increase prices. However, there is a cost to update your prices on the menu. This is just a simple example of why money is not completely neutral.

Central Bank Monetary Policy

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. This is one of the findings of Bill Phillips and his eponymous Phillips Curve, which indicates that inflation and unemployment have an inverse relationship. In other words, as wages increase (due to money growth), the rise in inflation reduces unemployment (or increases employment).

Milton Friedman built upon this and believed that money was not neutral in the short run, because economic agents (anyone who makes an economic decision) will always respond to changes in the money supply.

So, if a central bank were to increase the supply of money and, hence, the price level, agents can’t really distinguish between real and nominal changes, so they will regard the increase in nominal wages as real and boost labor supply.

Additional Resources

Thank you for reading CFI’s guide to Neutrality of Money. To keep advancing your career, the additional CFI resources below will be useful:

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