Neutrality of Money Concept in Macroeconomics - Essay Example

?Monetary economics Table of Contents Introduction: Neutrality of Money 3 Explanations provided by Macroeconomic schools of thought 4 ical Economics 4 Keynesian Economics and Monetarist Principles 5 New Classical and New Keynesian economics 6 Post-Keynesian Economics 7 Conclusion 8 References 8 Introduction: Neutrality of Money The concept of neutrality of money had first been proposed by classical economists who denoted that a rise in money supply could only affect nominal variables but not the real ones. In other words, a 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. This dissection between real and nominal variables as made by classical economists led to the development of a result called classical dichotomy. But fundamentals of this theory had been violated many-a-times in reality. For instance, USA could not check the inflationary pressures which had befallen the economy during 1979-1983 through reducing the domestic stock of money. In fact, in real practice it has been found that neutrality of money as defined by the classicals holds only during the long run while in short run, the impact of a change in money supply could influence the real variables as well. In USA for example, the change in money stock resulted to a fall in the rate of inflation only during the long run though it aggravated the rate of unemployment in the nation as an immediate aftermath. One strong argument presented against the applicability of neutrality of money as defined by classical economists is that in most of the cases, prices and wages are sticky in the short run and hence, cannot be altered within a short notice. 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 accommodated by the society given that it already operates at the full employment level. Hence, the natural implication of the situation is a rise in the equilibrium price level in the short run. At E”, the real stock of money stays unchanged and so has the level of equilibrium output (Dornbusch & Fischer, 207). The Quantity Theory of Money as popularised by classical economists stated that the price level prevailing in a nation moves in proportion to the change in money stock of the economy. The identity underlying the Quantity theory of money could be represented as follows – M x V = P x Y Where, M ? Stock of money supply, V ? Velocity of money circulation, P ? Price level and Y ? Aggregate output. In the short run, the aggregate level of output is fixed given that the economy is assumed to produce at the full employment level. If the velocity of money is considered to be fixed as well, then the Quantity Theory of money relates a rise in price level as a positive function of a rise in money stock, with the proportion of rise remaining fixed in the short run. In the long run however, when there is a revision in the full employment level, leading to a horizontal shift in the aggregate supply schedule the equilibrium level of output rises and the price level might come back to its initial level. However, in most of the cases this is not so given that the aggregate level of output is already heightened. Keynesian Economics and Monetarist Principles Keynesian economists later disapproved of the fundamentals underlying the concept of neutrality of money as pioneered by the classical economists. The Keynesians denied the flexibility of nominal variables such as price levels in the short run. They considered two intrinsic models to refute the classical theory of neutrality of money. These two models were respectively – Sticky wage model and Sticky price model According to the two models of Keynesian economics, level of price as well as wage negotiated between two parties cannot be adjusted at a short notice since it incurs substantial cost in fixation. Hence, even if the stock of money rises in the short run, it cannot lead to a hike in the general price levels in the economy. Keynes did not distinguish between short and long run periods of operation and hence, did not categorise the aggregate supply schedule to be inelastic in the short run. In other words, Keynes did not presume the equilibrium level of output to be produced at the full employment level in the short run. According to Keynesian economists, a hike in the supply of money results to an upward vertical shift in the aggregate demand schedule leading to a rise in the equilibrium quantity being produced as well as a hike in equilibrium price of output. This is popularly known as the monetary disequilibrium theory which says that a change in the nominal supply of money could actually result to a change in aggregate output being produced as well. The Quantity Theory of Money proposed by classical economists has also been revised by the Keynesians. Though the identity remains same, the successors do not suppose the velocity of money to be fixed. Instead the Keynesians argue that a hike in the supply of money instigates people to lower the velocity of per unit of money since they have an abundance of the currency around. Thus the primary distinction between classical economists and Keynesians about the occurrence of inflation was that while the former argued the phenomenon to be the result of the economy acting at the full employment level during the short run, the latter considered it to be an outcome of the stronger bargaining power of labour unions or due to the market power of monopolists (Handa, 513). However, during the long run, even Keynesians agree with the neutrality of money given the absence of constraints related with price and wage stickiness. Though the concept of long run is quite vague in case of Keynesian economics, theoretically, it is possible to achieve a situation of money neutrality when output remains at the full employment level and any demand shock only leads to a hike in price level. New Classical and New Keynesian economics The new classical economists have revised the arguments put forth by their forerunners through considering the nature of both price and output to be flexible in the short run. They have incorporated the theory of bounded expectations within their fundamentals. A bounded expectation is a modification over the concept of rational expectations. According to the new concept, the ways that the economic units act are the outcome of the information set that they are exposed to. In addition, every market participant behaves in a similar way so that no shock stays unanticipated. However, in case of bounded expectations, there arises a coordination failure between various market participants since not all of them are exposed to a similar set of information. In other words, they are all victims of asymmetric information which is the reason behind inflationary pressures in the market even though they assume the non-neutrality of money in the short run. On the other hand, new Keynesian economists too support the concept of bounded rationality to be a reason behind coordination failure. However, the fundamental area where they differ from new classical economists is that the former persist in their assumption of sticky prices prevailing in the short run which cause the aggregate demand schedule to shift vertically. Hence, there exists non-neutrality of money in the short run, though price levels might change due to coordination failure owing to bounded rationality. But the long run sees a neutral money as the economy starts producing at the full employment level. This is also true in case of new classical economics (Mankiw, ‘New Keynesian Economics’). Post-Keynesian Economics Fundamentals of Post Keynesian economics are the ones being followed today as the basics of monetary policy. It is an outcome of the Keynesian fundamentals which believe that money is neutral in the long run but not in the short run. Hence, to check any inflationary pressures it will not be a wise decision to fluctuate the stock of money in the economy since the price level stays fixed in the economy. Instead, the post-Keynesian economists emphasise upon altering the rate of interest prevailing in the economy to make the monetary policies effective. Conclusion 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. The only change which could be incorporated is a hike in the price level in the short run. On the other hand, the Keynesian economists revised the proposal of their classical counterparts through supporting neutrality of money only in the long run given their assumption that aggregate output could be adjusted in the short run. The new classical economists rectified their forerunners through incorporating the flexibility of output production so that neutrality of money applied only in case of long run. New Keynesian economists on the other hand, stuck to the fundamentals proposed by their antecedents and only added the concept of bounded expectations which solved the mystery of inflation even during the short run. However, the Post Keynesian economists who actually rule the order today have proposed a solution to the inflationary pressures created in the short run. Given that price is sticky in the short run, the only option through which a recessionary or an inflationary shock could be checked is through controlling the market rate of interest. Changes in money stock they say, can only have a relevant impact over the long run. References Dornbusch, Rudiger and Stanley Fischer. Macroeconomics. Book. New York: McGraw-Hill, 2005. Handa, J. Monetary Economics (2nd edition). New York: Taylor & Francis, 2009. Mankiw, N. G. " New Keynesian Economics ". The Concise Encyclopaedia of Economics. 28 February 2011. . Read More