Is Money Neutral - Essay Example

? Is Money Neutral? Ever since money was used to replace barter trade in the world, is has raised many questions as to its nature, especially in the world of economics, which forever remains curious about its effect on the economy. One of these major questions, which it raised, is whether money is neutral. This question is that is money a neutral force in the economy, or does the fluctuation of its interest rate affect the economy? The effects on the economy would include booms or recessions following fluctuations in the money rate of interest, since these fluctuations would lead to a misdirection of investment with every change. This is an important question to ask, as it affects the way, the government chooses to govern the economy and the ways to control it. The two schools of thought, the New Keynesian Theory and the Real Business Cycle Theory, debate the answer to this question (Mankiw, pp. 181-220, 2003). Both of these theories have a unique perspective to offer on the answer, and since each raises valid arguments, neither has yet been discredited for the other. The theory of money neutrality maintains that the effect of money does not affect real, inflation-adjusted factors like employment; real Gross Domestic Product (GDP) and ‘real’ consumption (real because they have are all adjusted for inflation). This is because this theory considers the force of money as an inflationary one, with no large implications for the economy in terms of the macroeconomic factors. However, the theory does acknowledge the impact money has on nominal variables, such as price and wages, and even exchange rate of the country’s currency (Wickens, pp. 199, 2009). These factors bound to gain influence from the money rate of interest, as they have a direct link to money and its circulation in the economy. The two schools of thought that debates on the neutrality of money have opposite views about how far-reaching the effect of money can be in an economy. The classical model states that money is neutral in both the short run as well as the long run. This means that this model considers money to be a neutral force, one that does not affect macro factors such as GDP or employment in the economy. Whereas, the Keynesian school of thought states that a force as strong as money does have its impact on the economy in the end. It believes that monetary policy does have a strong impact on the real economy, if one waits enough time before observing the changes. Each of these schools believes that this effect is visible within the short run for a short period of time, which is a factor on which they both see eye to eye, but for different reasons. For the long term however, they both offer opposing views (Wickens, pp. 199, 2009). The classical model presents the view that monetary policy cannot affect the real economy and its macro factors, neither in the short run, nor in the long-run (Gali, pp 50-79, 2008). It states that nominal shocks, which are changes in the money supply and money demand, do not have any effect on the business cycle. This monetary policy is one of the tools that a government uses to control the economy, which it does by manipulating the money supply and circulation. According to the theory, when ‘money supply’ changes, it affects price proportionately. However, there is no effect on the real variables in the economy, such as the real interest rate or the unemployment level in the economy. As mentioned above, the classical school does also believe that the money supply affects the real factors for a short period. However, it believes that very soon, the price level adjusts to this change in money supply, thus making it ineffective to any real factors in the economy. This is apparent in the diagram below, which shows how the equilibrium reverts to normal after a temporary price shock (Abel and Bernanke, pp. 2005). In other words, it believes that the non-neutrality of money is short-lived, persisting over a period of insignificant length. Thus, this school of thought regards money to be neutral for a period of any length. Experts who evaluated this theory came up with the query about why money still seems to have such a large effect on real variables in real life. They observed how changes in money supply are often followed by changes in the business cycle, and they questioned the accuracy of the classical model with regard to money neutrality, since this situation shows that money is not a neutral force as if they hypothesized it to be (Blanchard, pp. 87-159). To this, classical economists respond with the possibility of reverse causation. They say that just because money seems like a procyclical, leading factor in empirical evidence does not make it so in real life. They give the common example of rain and umbrellas, in order to clarify the point of reverse causation. When one thinks it may rain, they take an umbrella with them when they go outside (Abel and Bernanke, pp. 2005). If it happens to rain while they are outside, they will be sheltered from the rain due to their umbrella. Nevertheless, this does not mean that the umbrella caused the rain. In fact, it means that the possibility of rain caused the person to bring the umbrella. Thus, even though the event of bringing the umbrella preceded the event of rain, the former did not cause the latter. In the same way, even though the change of money supply may often precede the change in the business cycle, this does not mean that the money was the reason. These experts argue that even a prediction of increase in output will lead to an increase in money supply, and that a prediction of decrease in output may lead to an actual decrease in money supply. For example, an anticipation of higher demand would cause a firm to increase its money supply, so that it is able to pay its workers and suppliers for the extra labor and material. As shown in the diagram below, a higher output will lead to a higher demand for labor (Abel and Bernanke, pp. 2005). It would thus arrange for the extra money before the demand actually rises, but this would not mean that the following increase in output is due to the increase in money supply. This explains how reverse causation affects the relationship between money supply and output, keeping in view the classical model. The theory of reverse causation has led to further clouding of judgment about the non-neutrality of money. A few experts have conducted some studies in order to further explore this phenomenon, and deduce the accuracy of the classical model in this regard. In a classical study about monetary policy, Friedman and Schwartz studied further into this question. Through a thorough analysis of a year’s data as well as several journals, they concluded that money could often be an independent force, which is not always a product of changes in output or predictions of such changes. They also found that money does have a noted impact on factors like prices and wages (Abel and Bernanke, pp. 2005). The Keynesian school has a very different view to offer on money. It states that, unlike what the classical school believes, the prices and wages do not simply adjust quickly to changes in money supply. They do not absorb the blow of such a change and help restore equilibrium right away. In fact, the Keynesian school believes in a much more far-reaching effect. The new Keynesian theory believes that once there is a change in the supply of money, it can cause disequilibrium in the economy for long periods. This disequilibrium is not self-fixing, as the classical economists believe it to be in the real business cycle theory. It is rather something that the government needs to fix through active measures otherwise; it will not disappear and will instead cause problems. While the classical school believes that nominal factors such as price and wage are factors that help prevent change in the real economy after a monetary change, the Keynesian school considers these factors to be ‘sticky’ or ‘rigid’ (Abel and Bernanke, pp. 2005). This implies, as stated above, that consequent changes to economy will not always revert to equilibrium in their own. This theory expects rigidity from not only such nominal factors, but also factors such as unemployment, which is affected by real wage rigidity. This real wage rigidity can be explained by several different reasons. One reason could be that labor unions prevent the wages of their workers from reduction. This makes the prevailing price at this time ‘stick’. Another explanation is that a firm may end up paying its workers higher wages. It would do this to avoid a further increase in its costs (which have already increased due to the increase in money supply; thus making things more expensive), in labor turnover costs. This increase in wages would help the firm retain the workforce it already has, thus increasing the efficiency of the laborers, who will feel obligated to perform better due to their increased remuneration as the Efficiency Wage model predicts, as shown in the diagram below (Abel and Bernanke, pp. 2005). This sticky-price model from the Keynesian theory refers to when the price does not fluctuate when money supply fluctuates, thus leading to larger factors changing instead. A firm may not want to change its costs despite its increasing costs, for several reasons. They may be avoiding doing this in the face of monopolistic competition, or in the fear of menu costs (Blanchard, pp. 87-159). Monopolistic costs would not let a firm increase its costs without kicking it out of the competition, where one price prevails for all firms producing the same products. The menu costs would include all the costs that a firm would face if it increased its prices, including resultantly disgruntled customers as well fixed-price contracts that they would lose. There are several implications accompanying each school of thought regarding the neutrality of money. In addition, where these implications fall short of explaining the apparent effects of money, alternate explanations affect these theories. Experts have thus not been able to discredit on for the other. It thus remains an on-lingering debate whether money is a neutral force in the economy, and it is up to the experts to decide a course of action beneficial to the economy every time there is a change in output due to the effects of money. Works Cited Abel, Andrew B and Bernanke, Ben S. Macroeconomics. Addison Wesley, 2005. Blanchard, Oliver. Macroeconomics. Prentice Hall, 2006. Gali, J. Monetary policy, inflation, and the business cycle: an introduction to the new Keynesian framework. Princeton University Press, 2008. Mankiw, Gregory N. Macroeconomics. Worth Publishers, 2003. Wickens, M. Macroeconomic Theory: A Dynamic General Equilibrium Approach. Princeton University Press, 2009. Read More