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Neutrality of Money

Changes in the supply of money in an economy only affect nominal economic variables

What is the Neutrality of Money?

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

 

Neutrality of Money

 

The neutrality of money theory implies that the central bank does not affect the real (or major) variables within an economy. 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.

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

 

Summary: 

  • The neutrality of money states that increases in the money supply change only the nominal variables of the economy, not the major ones, over the long term.
  • Money is a means of exchange; when its supply increases, the value of each unit decreases and, therefore, it can’t be exchanged for the same value/amount.
  • Critics of the neutrality of money theory suggest that because of its nature, money isn’t, and never can be, neutral.

 

Superneutrality of Money

The idea of the superneutrality of money is significantly stronger than the neutrality of money theory. It outdoes the latter by stating that the real economy isn’t affected by changes in the level of money supply, but it is also isn’t affected by the rate at which the money supply grows. Both the superneutrality and neutrality of money concepts are used when looking at long-term models of the economy.

 

The Reality of Money

Money is a means of exchange, accepted around the world, regardless of the specific type or denomination. Money’s literal purpose is to be used in exchange for other things, namely goods and services. Money comprises a number of subfunctions:

  • Store of value
  • Medium of deferred payment
  • Unit of account

However, the functions are all just subsets of the primary purpose of exchange.

It should also be pointed out that money is, in fact, itself a good. It is, therefore, subject to the same rules and laws as other goods. The rule that perhaps stands out most is the law of diminishing marginal utility, which means that as the stock of money increases, its exchange value will drop accordingly. (The more the supply of money increases, the less each unit of money will be worth, meaning it can’t be exchanged for the same value or amount of goods and services.)

 

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.

In addition, when the money supply rises, it enables those who get 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.

 

More Resources

CFI offers the Financial Modeling & Valuation Analyst (FMVA)™ certification program for those looking to take their careers to the next level. To keep learning and advancing your career, the following CFI resources will be helpful:

  • Economic Indicators
  • Foreign Exchange
  • Inflation
  • Remuneration

Financial Analyst Certification

Become a certified Financial Modeling and Valuation Analyst (FMVA)® by completing CFI’s online financial modeling classes!