Neutrality Of Money

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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.

BREAKING DOWN '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.

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