wikipedia: “Neutral Money”

The Wikipedia entry on “Neutral Money”:

The term “neutral money” was coined by Friedrich Hayek, and was originally defined as a market coordinating money rate of interest which did not create a boom and bust cycle by falsely misdirecting investment through the time structure of production goods.[1]

Later Keynesians economists took up the notion and redefined it in terms that ignored the microeconomic time structure of production. On this later definition, neutrality of money is the idea that a change in the stock of money affects only nominal variables in the economy such as prices, wages and exchange rates but no effect on real (inflation-adjusted) variables, like employment, real GDP, and real consumption. It is an important idea in classical economics and is related to the classical dichotomy. Money neutrality holds that the central bank does not affect the real economy (e.g., the number of jobs, the size of real GDP, the amount of real investment) by printing money. Any increase in the supply of money would be offset by an equal rise in prices and wages.

Many economists maintain that money neutrality is a good approximation for how the economy behaves over long periods of time but that in the short run monetary-disequilibrium theory applies, such that money would affect output. One argument is that prices and especially wages are ‘sticky‘, and cannot be adjusted immediately to an unexpected change in the money supply. An alternative explanation for real economic effects from money supply changes is not that people can’t change prices (because of menu costs, etc) but that they don’t realize that they should. The bounded rationality approach suggests that small contractions in the money supply are not taken into account when individuals sell their houses or look for work, and that they will therefore spend longer searching for a completed contract than without the monetary contraction. Furthermore, the floor on nominal wages changes imposed by most companies is observed to be zero; an arbitrary number by the theory of money’s neutrality but a very real psychological threshold.

The New Keynesian research program in particular emphasizes models in which money is not neutral, and therefore monetary policy can affect the real economy.

1. Roger Garrison & Israel Kirzner. (1987). “Friedrich August von Hayek,” John Eatwell, Murray Milgate, and Peter Newman, eds. The New Palgrave: A Dictionary of Economics London: Macmillan Press Ltd., 1987, pp. 609-614.

  • Don Patinkin (1987). “Neutrality of money,” The New Palgrave: A Dictionary of Economics, v. 3, pp. 639-44. Reprinted in John Eatwell et al. (1989), Money: The New Palgrave, pp. 273287.
  • Friedrich Hayek (1933 in German). “On ‘Neutral Money’,” in F. A. Hayek. Money, Capital, and Fluctuations: Early Essays, edited by Roy McCloughry, Chicago, University of Chicago Press, 1984.
  • David Laidler (1992). “Hayek on Neutral Money and the Cycle,” UWO Department of Economics Working Papers #9206.
  • Roger Garrison & Israel Kirzner. (1987). “Friedrich August von Hayek,” John Eatwell, Murray Milgate, and Peter Newman, eds. The New Palgrave: A Dictionary of Economics London: Macmillan Press Ltd., 1987, pp. 609-614
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2 Responses to wikipedia: “Neutral Money”

  1. David says:

    Hi Greg. Thanks so much for maintaining the blog. I’ve learned a lot from it.

    I wonder whether it might be worth adding the notion that, in Hayek’s conception (at least as I understand it), monetary neutrality is a policy objective whereas, in the mainstream sense, neutrality is a characteristic of money under certain conditions.

    BTW, I have been hunating all over for a copy of the David Laidler article footnoted above. I don’t suppose you know whether it might be available online?

  2. The explanation is well explained and one can understand it easily.
    I would like to sagest that you do it in a graphical way, that is using graphic since it is an easier way for me to understand some economic tools.
    Thanks in advance.

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