Neutrality of Money - Essay Example

?Introduction Money plays a critical role in the monetary economics as it is believed that the control of money supply can actually result into the achievement of twin objectives of achieving the growth while at the same time managing the increase in price levels at acceptable rate. The major influence on the monetary economics and its central role in most of the developed economies has been from the work of Milton Friedman who actually first accepted the ideas of Keynesian economics however then went on to argue against them outlining the greater role of the equilibrium money supply and demand as the key variable for achieving the objectives of monetary policy in any economy. A central issue or debate in monetary economics however, rests with the neutrality of money i.e the increase in money supply results into an equivalent increase in wages and price level. The basic assumption behind the neutrality of money is that central bank potentially has no role in the economy as money does not tend to affect the real variables in the economy. Different views on the neutrality of money however, suggested that the changes in the nominal stock of money supply in the economy tend to affect the economy at least in the short run however, in long run money tend to behave as neutral. This paper will therefore attempt to explain and explore the notion of neutrality of money, the relevant debates on the neutrality of money and what are the different positions adapted by different schools of thoughts in macroeconomics. Neutrality of Money Neutrality of money is based on the assumption that the changes in the aggregate money supply in an economy can only affect the nominal variables. This therefore can result into the simultaneously increase in the prices as well as wages however, it will not affect the real output i.e. real GDP, level of unemployment or real price level in the economy. (Shaw, Greenaway, & McCrostie,1997). Classical economics suggested that the changes in the aggregate money supply in the economy is not going to change the aggregate demand for goods, services and technology in the economy. The term neutrality of money was originally coined by F Hayek indicating a market clearing interest rate which actually could not create booms and bursts under the market equilibrium conditions.( Saving, 1973). The later explanations of this concept therefore clearly established that the central bank does not have any role in the economy because changes in the money supply are not going to affect the economy and some of the nominal variables. This view was deeply held by the classical economists and was subsequently endorsed by the Keynesian model however, with the slight variations. The neutrality of money however is based on some fundamental assumptions such as the inflexibility of the prices, inelastic expectations as well as the absence of money illusion or distribution effects. Under these circumstances, it was generally agreed that the changes in the money supply can only create the changes in the price level as well as the wage rates without affecting the economy in real. Classical views on neutrality of money In order to understand the classical views on the neutrality of money, it is important to explore the idea of classical dichotomy. According to the classical dichotomy, there are two types of variables i.e. real and nominal. Real variables are being measured based on the relative prices whereas the nominal variables are measured in monetary terms. Thus according to the classical economics, the changes in the money supply can only affect the nominal variables and will not affect the real variables. The above graph shows that with the rise in the money supply, aggregate demand (AD) curve makes a parallel shift to AD’. However, since output is considered at the full employment level, a rise in the money supply will not change the output level and the output level will be restored back to the same level Y. One of the implications of this rise in the money supply and which is also depicted in the graph above is the rise in the price level. Classical economists assumed that since economy already operates at the full employment level therefore an increase in the money supply will eventually result into the increase in price level. It is also important to note that the classical views are mostly based on the assumptions of the long run and the concept of money neutrality has been based on the long run assumptions. However, in the short run, the overall changes in the nominal variables can affect the output, unemployment and price levels. Thus the more appropriate model to discuss the impact of changes in the money supply is described with the help of aggregate demand and aggregate supply framework. Keynesian views on Neutrality of Money The Keynesian views on the neutrality of money can be best described with the help of the IS-LM model and how the changes in the money supply can actually affect the output level in the short run. Keynesian views are based on the Sticky wage and Sticky price model outlining that both the wages as well as prices tend to react slowly to the changes in the economic variables. The Keynesian version of the IS-LM model suggests that the full employment line will be vertical however; the equilibrium in the labor market can only be achieved when the labor demand curve actually intersects the efficiency wage line and secondly the changes in the labor supply will not affect the employment level in the efficiency wage model. This is probably one of the most important assumptions suggesting a slight departure from the classical views on the equilibrium in the labor market and how the wages can increase with the increase in the money supply. According to this assumption, unlike classical economics where the equilibrium in labor market can be achieved when the labor demand meets the labor supply, the equilibrium in the labor market can only be achieved when the overall labor demand meets the efficiency wage. Under this assumption, the full employment line will be vertical but the reasons for its vertical nature are different from that of defined under the classical economics. It is also assumed that the efficiency wage is always higher than the market clearing wage therefore there will always be unemployment in the economy.( Abel & Bernanke, 2007). One of the major assumptions of Keynesian economics is that due to the stickiness of the prices, the economy does not need to remain in the general equilibrium while in the short run. However, prices are assumed to flexible in the long run. According to the Keynesians, the equilibrium point of the economy is always at the intersection of the IS-LM curve. It is also assumed that the assets markets adjust more rapidly and the overall level of output is determined by the aggregate demand. The above graph suggests that the changes in the money supply i.e. a shift towards LM2 has resulted into an increase in the level of output to Y2 from Y1 while keeping the IS curve at the same position. This Keynesian view is therefore suggests that the changes in the aggregate money supply in the economy do change the output level in the short run. The valid explanation of this assumption is based on the fact that the prices are fixed temporarily therefore the general equilibrium in the economy is not restored immediately with the changes in the money supply however, the equilibrium position will shift towards the new intersection point between IS and LM curve thus changing the aggregate output level. Keynesian views on the changes in the output level are based on the assumption that unlike competitive firms, monopolistically competitive firms do not change their prices but rather increase their output level thus increasing the new equilibrium output level higher than the output level at the full employment level. Firms facing the menu costs therefore do not increase their prices bur rather increase their output level in order to meet the new demand. This view therefore suggests that the changes in the money supply in the short run tend to create changes in the output level. The Keynesian model therefore predicts that the money is non neutral in the short run and can create significant changes in the aggregate output level in the economy. This view is based on the use of the expansionary monetary policy wherein increasing the monetary base by the monetary policy authority can significantly increase the output level. However, in order to achieve this, the interest rates have to be lowered in order to create what is called easy money to stimulate the growth in the economy. (Shaw, Greenaway, & McCrostie, 1997). It is also however important to note that Keynesian views on the neutrality of money are almost the same as those of the classical economists in the long run. It is argued that in the long run, the rigidity of the prices is not a permanent phenomenon therefore firms will gradually review their prices and subsequently adjust them thus allowing the economy to reach its long term equilibrium position. Thus when an expansionary monetary policy is exercised in the short run, firms find that the overall aggregate demand is higher than the planned output level therefore they ultimately start to increase the prices thus nullifying the affect of increase in the money supply. This therefore shifts the new LM curve back to its original position to restore the original equilibrium position. Neo-Classical School of Thought Neo-Classical school of thought is mostly based on the views of Chicago School and its major academic foundations were laid down by Milton Friedman. Friedman’s views on the neutrality of money are based on the arguments that the monetary policy actually could not be used to achieve the full employment level. Friedman argued that an increase in the money supply of x% may not result into the equivalent increase in the prices and wages (as predicted by the neutrality of money) because public may be simply unaware that they should also increase their prices by the same percentage as the changes in the money supply. This view therefore suggests that the monetary expansionary policy may not result into the decrease in the unemployment level but rather can result into acceleration of the economic activities without increasing the level of employment.( Walsh,2003). Friedman also put forward the notion of the causality between the output and the money. By establishing this causal relationship, Friedman showed that monetary instability in an economy can actually be the real instability. What is however, still unclear, is the establishment of the fact that whether growth of money supply results into higher output or the higher output derives the growth in money supply.(Lewis & Mizen,2000). Rational Expectations The views of the rational expectations theory is based on the assumption that the expectations for the recession are built by the individuals and businesses much before the actual recession occur in the economy. When the recessionary effects become visible in the economy, the rational individuals and businesses will actually reduce their wages and prices thus increasing the purchasing power of the dollar. This increase in the purchasing power of the dollar is considered as equivalent to the increase in the money supply. Thus when under the recessionary conditions, government increases the money supply it is not going to affect the prices or the wage levels as they have already been adjusted under the rational expectations of the businesses and the households. This view is therefore is considered as a complete opposite of the Keynesian views on the neutrality of money and suggest that the increase in the money supply, in the short run, may not result into the equivalent increase in the prices and the wages as they have already been adjusted according to the expectations. The only way the neutrality of money can work in the short run is therefore for central bank to exceed the expectations of the businesses and households and increase the money by greater proportion than expected by the different economic agents. (Shaw,1984) Conclusion Neutrality of money suggests that the increase in the money supply will increase in an equivalent increase in the prices and wages. Due to this reason, only nominal variables in the economy change and real variables remain unaffected. Keynesian views however, suggested that the neutrality of money does not exist in the short run because of the behavior of the monopolistically competitive firms. The views of Friedman and rational expectations theory however, suggest otherwise. References 1. Abel, A & Bernanke, B, (2007). Macroeconomics. 5th ed. New York: Prentice Hall. 2. Lewis, M, & Mizen, P( 2000). Monetary Economics. 1st ed. Oxford: OUP 3. Saving, T, (1973). On the neutrality of Money. The Jorunal of Political Economy, (81/1), 98-119. 4. Shaw GK (1984) Rational Expectations: An Elementary Exposition, Brighton: Wheatsheaf 5. Shaw, K, Greenaway, D & McCrostie, M (1997). Macroeconomics: Theory and Policy in the UK . 3rd ed. London: Wiley-Blackwell. 6. Walsh, C, (2003). Monetary theory and policy. 2nd ed. New York: MIT Press. Read More