Money Neutrality: Explanation, Critics

Money neutrality says that, in the long run, changes in the money supply only changes the price level, and do not affect real variables such as output and employment.

So, when the central bank increases the money supply, it will not increase the long-run output (potential GDP). By printing more money, more money chases fewer goods, causing a jump in the prices of products, services, and wages.

The logic of money neutrality

Printing more money cannot change the nature of the economy. The quantity theory of money states that the amount of money in circulation (M) and its circulation (velocity or V) in the economy must be equal to the level of prices (P) and real output (Y). Velocity is assumed to be constant, so when the money supply increases, there are two possibilities, real output rises, the price level rises, or both combined.

M x V = P x Y

In macroeconomics, long-term output increases when the economy has additional capacity to produce it. The increased productive capacity of the economy shifts the long-run aggregate supply curve to the right, causing the real output to increase. Increasing the productive capacity of the economy depends on the quantity and quality of factors of production and technological progress.

In conclusion, long-term output growth is determined by non-money supply factors. So, in the long run, when the money supply increases, it will only result in price increases.

Superneutrality of money

The superneutrality of money is a stronger postulate than the neutrality theory of money. In the postulate, not only the amount but the growth in the money supply also does not affect the real economy. Both are used to see the long term economy.

Critics

Many economists reject the concept of money neutrality. Some econometric studies show that variations in the money supply affect real prices over long periods.

When the money supply grows, it raises inflation, which causes a decrease in the real return on money. Therefore, people choose to reallocate ownership of their assets away from cash to real assets such as productive assets. That means there is a decrease in real money demand.

When the real demand for money changes, the supply of loanable funds changes. A combination of the difference in the nominal interest rate and the inflation rate causes real interest rates to change from before. If so, real spending on physical capital and durable consumer goods can be affected.