Neutrality Of Money

AAA

DEFINITION of 'Neutrality Of Money'

An economic theory that states that changes in the aggregate money supply only affect nominal variables, rather than real variables; therefore, an increase in the money supply would increase all prices and wages proportionately, but have no effect on real economic output (GDP), unemployment levels, or real prices (prices measured against a base index). The neutrality of money is based on the idea that changing the money supply will not change the aggregate supply and demand of goods, technology or services. It was a cornerstone of classical economic thought, but modern-day evidence suggests that neutrality of money does not fully apply in financial markets.

INVESTOPEDIA EXPLAINS 'Neutrality Of Money'

The neutrality of money is considered a plausible scenario over long-term economic cycles, but not over short time periods. In the short term, changes in the money supply seem to affect real variables like GDP and employment levels, mainly because of price stickiness and imperfect information flow in the markets.

Central banks like the Federal Reserve monitor the money supply closely, and step in (through open market operations) to change the money supply when conditions deem it necessary. Their actions indicate that short-term money supply changes can and do affect real economic variables.

Economists generally feel that certain elements like wages have stickiness to them; employers can raise wages but lowering them is nearly impossible in a practical sense. Also, companies are reluctant to make minor changes to prices just because of a slight change in the money supply. Effects like this undermine the conclusions that can be reached from short-term analysis of the neutrality of money.

RELATED TERMS
  1. Sticky-Down

    A figure that can move higher relatively easily, but only will ...
  2. Price Level

    The average of current prices across the entire spectrum of goods ...
  3. Price Stickiness

    The resistance of a price (or set of prices) to change, despite ...
  4. Quantity Theory Of Money

    An economic theory which proposes a positive relationship between ...
  5. Federal Reserve Board - FRB

    The governing body of the Federal Reserve System. The seven members ...
  6. Cape Cod Method

    A method used to calculate loss reserves that uses weights proportional ...
RELATED FAQS
  1. What does the Fisher Effect say about nominal interest rates?

    The Fisher effect is a theory first proposed by Irving Fisher. It states that real interest rates are independent of changes ... Read Full Answer >>
  2. Does raising the minimum wage increase inflation?

    There are conflicting views on whether raising the minimum wage increases inflation. Tied to this is the question of what ... Read Full Answer >>
  3. How do open market operations affect the money supply of an economy?

    The open market operations conducted by the Federal Reserve affect the money supply of an economy through the buying and ... Read Full Answer >>
  4. What is the difference between the cost of capital and the discount rate?

    The cost of capital refers to the actual cost of financing business activity through either debt or equity capital. The discount ... Read Full Answer >>
  5. What risks does a business owner face under a business structure with unlimited liability?

    The risks that a business owner faces under a business structure with unlimited liability are literally unlimited, but they ... Read Full Answer >>
  6. What is affected by the interest rate risk?

    Interest rate risk is the risk that arises when the absolute level of interest rates fluctuate. Interest rate risk directly ... Read Full Answer >>
Related Articles
  1. Economics

    Economics Basics

    Learn economics principles such as the relationship of supply and demand, elasticity, utility, and more!
  2. Economics

    The Uncertainty Of Economics: Exploring The Dismal Science

    Learning about the study of economics can help you understand why you face contradictions in the market.
  3. Fundamental Analysis

    What Is the Quantity Theory of Money?

    Take a look at the tenets, assumptions and challenges of monetarism's principal theory.
  4. Economics

    Explaining Financial Analysis

    Financial analysis is a general term that refers to using financial data to make business and investment decisions.
  5. Economics

    When Global Economies Converge

    The Divergences in global economic look very much like an explanation for what happened last year, though market observers continue to tout about it.
  6. Investing

    Do Record Stock Highs Signal A Top?

    Despite higher rates, U.S. stocks have been posting new records in recent weeks, despite investor concerns about slowing U.S. corporate profit growth.
  7. Bonds & Fixed Income

    Abenomics Vs. Quantitative Easing: Which Works Best?

    Abenomics and QE are versions of extraordinary stimulus measures initiated by the Japanese government and the U.S government, respectively.
  8. Economics

    West Coast Vs. East Coast Economy

    The East’s focus on finance and banking contrasts the West’s drive toward technological innovation. But one thing is clear--each knows it needs the other.
  9. Investing Basics

    What is a Nominal Value?

    The nominal value of a security, such as a stock or bond, remains fixed for the duration of its life.
  10. Economics

    Explaining the Human Development Index

    The Human Development Index (HDI) is a metric developed by the United Nations to take the emphasis off economic growth and focus on human wellbeing.

You May Also Like

Hot Definitions
  1. Fracking

    A slang term for hydraulic fracturing. Fracking refers to the procedure of creating fractures in rocks and rock formations ...
  2. Mixed Economic System

    An economic system that features characteristics of both capitalism and socialism.
  3. Net Worth

    The amount by which assets exceed liabilities. Net worth is a concept applicable to individuals and businesses as a key measure ...
  4. Stop-Loss Order

    An order placed with a broker to sell a security when it reaches a certain price. A stop-loss order is designed to limit ...
  5. Covered Call

    An options strategy whereby an investor holds a long position in an asset and writes (sells) call options on that same asset ...
  6. Butterfly Spread

    A neutral option strategy combining bull and bear spreads. Butterfly spreads use four option contracts with the same expiration ...
Trading Center