Neutrality of Money Essay Example | Topics and Well Written Essays - 2000 words

Neutrality of Money - Essay Example 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 classic al 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