Monetary Neutrality

In economics, the principle of monetary neutrality holds that changes in the circulating money stock leave no lasting impact on the quantity of goods and services produced, unemployment rate, wages measured in real purchasing power, or other indicators of economic prosperity. To understand the concept of monetary neutrality, it helps first to understand what economists mean by real variables. In economics, nominal variables are not adjusted for inflation whereas “real” variables are adjusted for inflation. If the average nominal wage in the United States doubled over a span of time, and prices on average doubled over the same span of time, then economist would say that real wages remained constant. Wages doubled, but prices doubled. The result was that the real purchasing power of wages remained constant, and the standard of living of wage earners saw no change. The same principle applies to other variables. If the money supply doubles, but prices double, the real money supply remains constant. The real wage equals the nominal wage divided by the average level of prices. The real money supply equals the nominal money supply divided by the average level of prices. The “real interest rate” equals the contracted or quoted interest rate minus the inflation rate.

The principle of monetary neutrality claims that even the real money supply will not be impacted by a change in the nominal money supply. If monetary authorities double the money supply, then after a period of adjustment prices will double as a result, and the real money supply will return to its original level. The real money supply is a function of other real variables, such a real output and real interest rates. According to monetary neutrality, real variables are functions of other real variables. There is no causal nexus between changes in the circulating money supply and real economic variables.

The principle of monetary neutrality casts some doubt on the value of monetary policy. All advanced nations have central banks that adjust domestic money stocks to meet the needs of trade and economic activity. If the only impact of a 10 percent increase in the money supply is to increase prices by 10 percent, one might ask whether anything useful is being accomplished. The answer lies in a consensus that the principle of monetary neutrality does not hold in the short run. Changes in the money supply do not directly impact prices, and in the adjustment process, real variables are effected temporarily. The strongest adherents of monetary neutrality tend to favor a nonfluctuating rate of monetary growth that is in line with the overall growth in economic activity.

The principle of monetary neutrality has strong logical and theoretical foundations, but it is difficult to verify empirically. Economic data clearly shows that the principle does not hold in the short run. To test the principle as a long-term concept, the money stock would need to be held constant for a long span of time, giving the economy plenty of time to adjust to the last change in the money stock. Then the economy would have to undergo a one-time, abrupt change in the money stock. With the money stock held constant at the new level, the economy would be given plenty of time to assimilate the new money, allowing ample time for adjustments to work themselves out. These conditions are never met in the real world.

Even with the difficulties of establishing it with unimpeachable proof, the principle of monetary neutrality serves as a warning against the abuse of monetary policy. It shows that increases in the money supply are not a road to permanent increases in prosperity. In a recession, accelerated money stock growth may help bring the unemployment rate back to more normal levels, but cannot permanently peg the unemployment rate at an unusually low rate.