What is Neutrality of Money?
A staple in classical economics, 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 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.
- Neutrality of money states that increases in the money supply change the nominal variables of the economy, but 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
Superneutrality of money is significantly stronger than neutrality of money. It outdoes the latter theory 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. It means that prices and wages are proportional to the money supply not only regarding the one-time changes to the supply but also to permanent changes in the growth rate of the money supply. Both superneutrality and neutrality 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 the money is, in fact, 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 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 and can never be 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 sudden surplus of money. It means that those receiving the money later will be forced to pay higher prices. It 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.
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