This paper talks about the concept of neutrality of money, which was introduced by classical economists and about the evolution of the concept in the successive schools of thought. It implies, that a rise in money supply could only affect nominal variables but not the real ones…
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This paper offers a comprehensive analysis of the evolution of views of different economic schools of thought on the concept of money neutrality. Neutrality of money had been a concept popularised by classical economists who assumed that output at any point of time is being produced at the full employment level and hence, cannot be adjusted in the short run.
Change in money supply could actually lead to a change in the general price level of the economy without creating any influence over its aggregate demand and supply schedules, rate of employment and interest rate. Thus, varying the amount of money in circulation in an economy could actually result to a controlled inflationary environment in the concerned nation.
The primary reason behind the applicability of neutrality of money is the inelastic aggregate supply curve in the economy. A rigid supply results to a rise in price level in the nation though relative price of commodities remain fixed. On the other hand, as wages also increase proportionally, there is no adjustment on the aggregate demand frontier. Hence, the impact of a change in money supply only results to a change in the general price level in the short run. The dissection between real and nominal variables as made by classical economists led to the development of a result called classical dichotomy.
The concept has been revised a large number of times by economists belonging to successive schools of thought. As it has been found that neutrality of money holds only during the long run.
This is the reason why the concept has been revised a large number of times by economists belonging to successive schools of thought. Explanations provided by Macroeconomic schools of thought The following paragraphs elaborate the stance posed by various macroeconomic schools of thought regarding the neutrality of money. It was proposed first by the classical economists but had later been revised by its successors during different real-life economic crises. Classical Economics The classical economists were of the view that a change in money supply actually does not affect aggregate supply in the nation. In fact, they assumed aggregate supply of money to be inelastic at any point of time. In other words, the economy always produces at its full employment level so that the equilibrium output being produced is always fixed. In the short run, the position of the schedule stays fixed while in the long run, it shifts horizontally without creating any impact on the slope of the curve. Hence, a rise in money supply actually results to a shift in the aggregate demand given the immediate rise in the wage structures. The diagram alongside illustrates the situation which had been depicted by the classical economists. It shows that a rise in money supply in the economy results to a vertical shift in the aggregate demand curve. But the ultimate outcome remains unaltered with the equilibrium output staying fixed at Y* though the equilibrium price level rise from P0 to P’. Initially, a shift in aggregate demand curve creates a pressure upon the equilibrium output inducing a shift in equilibrium point from E to E”. But such a pressure cannot be
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