What is the neutrality of money? Definition and meaning

The definition and meaning of the neutrality of money, also referred to as monetary neutrality or neutral money, is a notion that any change in the money supply makes no difference to real economic variables such as employment, real consumption, real interest rates, or GDP (gross domestic product). If a country’s central bank doubles the money supply, prices will increase by the same amount. If there are twice as many units of a country’s currency in circulation, each one will be worth just half as much as before – everything cancels each other out because they all increase equally, resulting in no real economic change.

Price levels might change as a result of increasing the money supply, but not output or the structure of the country’s economy.

According to BusinessDictionary.com, the neutrality of money by definition is:

“Situation where economic indicators. such as level of employment and real (inflation adjusted) output, are not affected by changes in the money supply.”

Neutrality of moneyThe central bank may boost the money supply by printing more money. Prices will rise, but GDP, employment and real investment will remain the same – so the monetary neutrality theory goes.

Neutrality of money – classical economics

The neutrality of money theory is a core belief of classical economics. It was first proposed by David Hume (1711-1776), a Scottish historian, economist, philosopher and essayist, best known today for his highly influential system of radical empiricism, naturalism and skepticism.

Hume set out the classical dichotomy that there are two types of economic variables – nominal and real. He explained that whatever influences nominal variables may not necessarily have an impact on the real variables, i.e. the real economy.

Examples of nominal variables in the economy are exchange rates, wages and prices. Examples of real variables are output (GDP), the amount of real investment, and employment.

While Hume thought up the concept of monetary neutrality, the term ‘The Neutrality of Money’ was first used by continental economists at the beginning of the twentieth century.

When Friedrich Hayek (1899-1992), an Austrian-British economist and philosopher, best known for his defense of classical liberalism, introduced the term in 1931, it exploded as a special topic in economic literature, especially those written in the English language.

Neutrality of money - different variablesAccording to the classical dichotomy, different forces have an effect on real and nominal variables.

Monetarism and the neutrality of money

Current economists who support monetarism believe that pure monetary neutrality does not exist in the real world, specifically in the short term.

In the short run, altering the money supply may affect real variables, such as employment, but in the long run, after the money circulates throughout the economy, the neutrality of money establishes itself again, i.e. the real economy is unchanged, say monetarist economists.

The Superneutrality of Money, an even stronger property than neutrality of money, holds that not only is the real economy totally unaffected by money supply changes, but also that the rate of money supply growth has absolutely no effect on real variables.

In this case, nominal prices and wages remain proportional to the nominal money supply not only in response to one-off permanent changes in the nominal money supply, but also in response to permanent changes in the rate at which the nominal money supply grows.

‘Helicopter Drop’ story

Milton Friedman (1912-2006), an American economist who was awarded the 1976 Nobel for Economics, gave the example of the ‘helicopter drop’ to explain the neutrality of money. Imagine a community in perfect economic equilibrium, when suddenly the following occurs:

“Let us suppose, then, that one day a helicopter flies over our hypothetical long-stationary community and drops additional money from the sky equal to the amount already in circulation-say, $2,000 per representative individual who earns $20,000 a year in income.”

”The money will, of course, be hastily collected by members of the community. Let us suppose further that everyone is convinced this event is unique and will never be repeated….”

“…People’s attempts to spend more than they receive will be frustrated, but in the process these attempts will bid up the nominal value of goods and services. The additional pieces of paper do not alter the basic conditions of the community. They make no additional productive capacity available.”

”They alter no tastes….the final equilibrium will be a nominal income of $40,000 per representative individual instead of $20,000, with precisely the same flow of real goods and services as before.”

Helicopter BenThe nickname ‘Helicopter Ben’ stuck after Ben Bernanke referred to Milton Friedman’s story in a speech in 2002.

The helicopter drop, also known as helicopter money, is used today when referring to the printing of large sums of money and distributing it to people in the hope of stimulating the economy. It is largely a metaphor for unusual measures to kick-start the economy during recessions and deflationary periods.

In the 21st century, the term gained popularity again when Ben Bernanke referred to it when he was a new Federal Reserve (Fed) governor in a 2002 speech. He became known as ‘Helicopter Ben’, a nickname that stuck, even when he was Chairman of the Fed.

Video – The neutrality of money – Definition and Meaning

In this video, Dr. Arnold Kling explains what the Neutrality of Money is, and that it is a topic in monetary theory. He gives us a scenario in which some elves came in during the night and added a zero to the end of every monetary unit in the economy.