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Cantillon Effects and Money Neutrality

June 27, 2017
in Blog

Money neutrality is a key principle in monetary economics. As might seem obvious, the amount of goods that can be produced depends on the availability of factors of production (such as capital and labor) and on technological knowledge. For instance, the fact that more dollars are in circulation does not mean we can produce more tables and chairs. But if we have better technology, more labor, or more wood, then we can produce more tables and chairs.

On the other hand, Cantillon Effects are equally plausible. The Cantillon Effect refers to the change in relative prices resulting from a change in money supply. The change in relative prices occurs because the change in money supply has a specific injection point and therefore a specific flow path through the economy. The first recipient of the new supply of money is in the convenient position of being able to spend extra dollars before prices have increased. But whoever is last in line receives his share of new dollars after prices have increased. This is why when the Treasury’s deficit is monetized, inflation is referred to as a non-legislated tax. In these cases, the government has seized purchasing power (rather than physical bills) from its citizens without congressional approval.

Can these two convincing intuitions be compatible with each other? In principle, it could be argued that Cantillon Effects focus on the short-term effect of changes in money supply, but that money neutrality is a long term characteristic of money. Short-run effects in resource allocation are typically not denied, usually due to the fact that they alter “sticky” prices, such as wages.

However, it is important to point to one key difference between the scope of Cantillon Effects and money neutrality. The Cantillon Effect refers to relative prices at the micro level. Money neutrality, on the other hand, refers to the aggregate production function, which means that relative prices are only captured in general terms, such as the real wage captured as a nominal wage index over a price-level index.

The first issue to note about this difference in scope is that the same wage and price-level indices could be attained with different relative prices at the micro level. It is possible that a change in money supply could trigger a change in relative prices at the micro level that ultimately results in the same wage and price levels. But this means that the composition of output would be different with and without the change in money supply. This composition of output is absent when money neutrality is envisioned as the level of output, independent of money supply.

Let us say that demand for each good is determined by consumers’ preferences and that supply is determined by the availability of factors of production and technology. If for some period of time a change in money supply alters resource allocation, then sustaining that money is neutral in the long-run (meaning that the economy always converges to the same equilibrium), then the equilibrium determinants should remain unchanged. In other words, the short-run effects of a change in money supply should not have an effect on either consumer preference or on factors of production. There are no reason for this to be the case. This means that money neutrality (at the micro level) is an assumption more than a fact.

Money neutrality might be a useful assumption in some cases. But money neutrality should not be taken as a fact, especially by policy-makers who might ignore the long-term consequences of monetary policy.