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Neutral Money?

April 28, 2011

The idea of money neutrality is a cornerstone in formal monetary theory. It is not free, however, of some controversy. If there are changes in money supply, why will the economy converge to the same equilibrium and not to a different one? If changes in money have a neutral effect in the long run, then the monetary authority can put into motion different monetary policies to deal with short term problems with the argument that in the long run all the effects are washed away and his policy is in fact neutral to the market equilibrium. If this is not the case, then it is not so clear anymore that money changes do not affect the long run stability of the economy. If money neutrality is an assumption, then it is important to notice if it holds or not.

First we need to differentiate between the ideas of monetary veil and money neutrality; they are not exactly the same and to separate them makes the analysis more clear.

Monetary veil refers to the fact that ultimately individuals change goods for goods in the market, but use money as an instrument to make those transactions cheaper and feasible. The economist should see beyond the monetary veil and spot what is going on in the market. This idea, applied to the equilibrium implies that once the market is in equilibrium, what matters are relative prices and not the level of prices (quantity of money). The veil of money can also be related to the discussion if money should be treated just as another commodity in the market. Money neutrality, however, is a different idea. While the concept of monetary veil is concerned with the market structure in equilibrium, money neutrality refers to changes in money before the market has reached its equilibrium. Monetary veil, applied to the market in equilibrium, is concerned with the final state of the market; but money neutrality deals with changes in money in a market in disequilibrium.

Then, a relevant question arises. If we move away from static changes in equilibrium where there is no place to a monetary shock outside equilibrium and the difference between monetary veil and neutrality becomes unclear, and we assume a monetary shock before the market is in equilibrium, what are the requirements for the market to converge to the same equilibrium it would have converge had the monetary shock not taken place? For this to happen, the determinants of the equilibrium structure should be fixed. There may be many of them, but we can focus on two that are relevant enough: 1) individual preferences and 2) capital goods heterogeneity.

Changes in money affect different economic agents at different times and places and in different extent. This is sometimes called Cantillon Effect. If, for example, a central banks increases the quantity of money, then there’s someone who receives the new money first. Who ever receives the new money fist (i.e. the government to finance fiscal deficit) has the advantage of receiving an extra amount of money that has not loose its purchasing power yet. As the new money is spent, the currency looses purchasing power as prices increase, and the last person to receive his share of the new money supply does it only after the prices has increased. This is the reason why it is said that inflation is an implicit tax to the population (in many cases to the poor or less wealthy). Some people see their income increase and others decrease, they change their consumption and this leads to changes in relative prices. What guarantees that during all this process the preferences of the individuals will not change? Are preferences engraved in stone? If this new situation the market triggers changes in subjective preferences, then the conditions of the equilibrium are modified and the change in money supply cannot be considered neutral in the long run.

The heterogeneity of capital goods has a similar effect. Because of the Cantillon effect and the changes in relative prices, capital goods are invested in a different pattern. This is unimportant if capital goods are because they can be reallocated without a loss. But, if capital goods are heterogeneous, then this is not the case anymore. Heterogeneity does not necessarily mean that a capital good cannot be reallocated at all, it implies that it cannot be done for free; if that were the case then it would actually be homogeneous. But, if to reallocate capital goods is costly, then some capital goods have to be consumed to properly adapt the capital goods to the new use. This affects the total endowment (and structure) of capital goods and so the equilibrium conditions will be affected. If capital goods are heterogeneous, then changes in money supply cannot be neutral in the long run.

One may, nonetheless, want to assume money neutrality to isolate the effects of the non-neutral effects when constructing a model. This may or may note be convenient depending on what is being analyzed. It is a very different situation, however, when recommendations for monetary policy are put forward. In this case to assume money neutrality is not trivial. One needs to ask (and answer) which assumptions are more plausible: 1) preferences will be fixed or not and 2) are capital goods heterogeneous or not? If it is more plausible that preferences will be affected and capital goods are heterogeneous then money neutrality is the wrong assumption. Just as a surgeon works with the most plausible assumptions when trying to heal a patient, the economist also needs to work with the more plausible assumptions when dealing with monetary policy and their theoretical foundations.

To put forward a sound monetary policy it is not only about high technical standards, but also about making the correct assumptions regarding the problem at hand. If the assumptions do not hold, then no matter how high standard our techniques are, the results will be biased and maybe unstable.

Nicolas Cachanosky is a doctoral student in economics at Suffolk University, as well as a previous Sound Money Essay Contest winner.

Image by Carlos Porta / FreeDigitalPhotos.net.