What it means
Money is a unit for measuring and exchanging value, and not a thing that creates value by itself. If every price, wage and bank balance doubled overnight, people could buy exactly the same goods as before.
The idea of neutrality says that, over time, this is what happens when a central bank prints more money. The classic formula behind it is the quantity theory of money.
It says that the money supply multiplied by the speed at which money changes hands equals the price level multiplied by the real quantity of output. If the speed of circulation and the real output are fixed, more money simply means higher prices.
This is important for inflation policy. If money is neutral in the long run, a central bank cannot create lasting growth or jobs by printing money, and it can only create inflation.
That is a main reason many central banks focus on keeping inflation low and stable and leave growth to factors such as technology, skills and investment. In the short run, though, most economists believe money is not neutral.
Wages and prices adjust slowly, so a cut in interest rates or an increase in the money supply can raise spending and employment for a time before the price effects arrive. This is the basis of monetary policy as practised in the real world.
A related idea, super-neutrality, goes further and says that even the growth rate of money does not affect real variables. Empirical evidence for it is weaker.
Business leaders can take away a simple message: nominal growth driven by inflation is not the same as real growth, so profits and sales figures should be judged in real terms.
In practice
Real-world examples.
Example
A country's central bank doubles its money supply over several years. Over the long run, the average price of a basket of goods rises from $100 to roughly $200 while the number of goods produced is unchanged. Workers' wages also double, so their buying power is the same.
Example
A manufacturing firm sees sales grow from $20,000,000 to $24,000,000 in a year when general prices rose 20%. The finance director points out that real sales have not grown at all. The board uses inflation-adjusted figures to judge performance.
Example
A central bank cuts interest rates during a downturn and unemployment falls over the next year. Economists argue this shows money is not neutral in the short run. Two years later, higher prices emerge, which fits the long-run view.
Formula
Calculation
Equation of exchange: Money supply (M) x Velocity (V) = Price level (P) x Real output (Q)
Therefore: P = (M x V) / Q
Suppose an economy has a money supply of $10,000, velocity of 4 and real output of 40,000 units. The price level P = ($10,000 x 4) / 40,000 = $1.00 per unit. If the money supply doubles to $20,000 while velocity and output remain the same, P = ($20,000 x 4) / 40,000 = $2.00 per unit. Prices double, but real output stays at 40,000 units, so money has been neutral.Case study
Seen in the real world.
Zandria is a fictional country invented for this illustrative story. Its government pressed the central bank to print money to pay for public projects, believing that more money would make the country richer. In the first year, spending rose and unemployment fell, which made the policy look successful.
By the third year, prices had risen by 60% and wages followed, while the number of goods produced was no higher than before. Savers lost buying power and a business that had signed a fixed-price contract for $5,000,000 found its costs rising faster than its income. The central bank finally tightened policy, and analysts used the episode as a textbook example of why money is neutral in the long run.
Watch out
Common mistakes.
- Believing that printing money makes a country richer. Real wealth depends on output, productivity and resources.
- Assuming money is neutral at every time horizon. Most economists think it has real effects in the short run.
- Confusing nominal and real figures. Growth that only reflects higher prices does not improve living standards.
Questions
People also ask.
Does neutrality mean monetary policy is pointless?
No, because policy can smooth out short-run swings and keep inflation stable, even if it cannot permanently raise output.
How long is the long run?
There is no fixed period, but economists often mean the time it takes for wages and prices to adjust fully.
Who developed the idea?
It has roots in classical economics and the quantity theory, and it was developed by many economists over a long period.
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