Neutrality of money

The in incompatibleity of property refers to the nonion that the effect of changes in an prudences nominal picture of money will consider no effects on the trustworthy variables like the documentary GDP, employment and enjoyment of goods and services and precisely the nominal variables such as the prices, wages and the exchange deem be affected. It was the standard feature of the true1 macroeconomic model of unemployment and inflation that was found upon the assumption of quickly clearing perfectly private-enterp burn down(a) grocery stores and the money market was g overned by the beat theory (Ackley, 1978).This resulted in what was known as the classical dichotomy the real and fiscal sectors of the economy could be analysed sepa footsteply as real variables like end product, employment and real interest rates would not be affected by whatever was going on in the nominal segment of the economy and vice-versa. The objective of the present endeavour is to seek t his concept of disinterest by delving into its theoretical motivations and buns and thereby introspecting upon the consequence to which distinguishing between forgetful prevail and colossal sway neutrality are important before briefly exploring the possible methods of empiric anyy investigating the printing and concluding.In the standard classical macroeconomic model, which was the basis of answering all macroeconomic questions before Keyness General theory brought forth its capturing charge onto it, the connection between the money supply and the price level was do through the quantity theory thus implying that the price level would turn to ensure the real aggregate withdraw, which was assumed to be a intimacy of the real money supply, was in alignment with the available supply of output inflexible in the market for labour.The quantity theory simply posits that real money balances are necessitateed in proportion to real income. This screwing be expressed asMD/ P = ( 1/v).Y where MD represents the nominal demand for money balances, P the price level, v the velocity of circulation of money and eventually Y the real GDP. Now by assumption, v is constant MD equals the supply of money which is exogenous (MD, = MS = M) in equilibrium and Y is fixed at its equilibrium value (Y= Y*) determined in the labour market. As a result the quantity theory par essentially becomes an equation that determines the price level for different levels of money. We have, P = v.(M/Y*) .Evidently, changes in the money supply now shall only influence the prices. This is the basis of the notion of neutrality of money which therefore is a direct derivative of the assumption of the quantity theory itself (Carlin and Soskice, 1990).An cast up in the supply of money initially leads to a rise in the aggregate demand preceding(prenominal) the real output (Y*, which is exogenous to the money market) due to increased availableness of cash balances. Due to the senseless demand situation the prices are pushed up until the demand for real output reduces to equal the supply of it. Note that in the classical system, the rate of interest plays the role of par savings and investing at full employment and does not enter the money market.However, in the 1930s the great depression which was essentially a situation of cascading tidy sum unemployment had no convincing explanation in terms of the classical poser which proposed that an economy would always operate at full employment. This situation of tidy sum unemployment and the lack of forthcoming explanations of the phenomenon in terms of the classical full-employment framework provided the scope for the introduction of the Keynesian model of unemployment.Although he upheld the assumption of perfectly competitive markets, he assumed prices to be fixed and money wages to be rigid and inflexible especially in the downward direction in the short run thereby implying the inability of the prices and wages to adju st to excess supply situations in the labour market employment and output were determined by the effective aggregate demand in the product market. expenditure was assumed to be a function of real income implying savings, essentially the curio of real income after consumption to be a function of real income as well rather than a function of real rate of interest as in the classical framework, and aggregate demand was make up of the planned expenses for consumption, investment and government expenses (for a closed economy). irrelevant to the classical model, in the Keynesian framework the rate of interest serves in equating real demand and supply of money rather than equating investment and full employment savings. This set up not only brings forth the possibility of equilibrium with unemployment prevalent in the labour market, it alike dispels the concept of neutrality of money. An exogenous increase in the money supply through its effect on the real rate of interest affects the follow of investment and through that causes a change in the aggregate demand and thus in the real output and employment. So, this framework proves the non-neutrality of money the short run (Mankiw, 2000).But in the dogged run, money can be deemed to have neutral effects through the following reasoning. An increase in the money supply will reduce the interest rates and increase investment. However, as the money supply rises, the real stock of money balances exceeds the want level thus necessitating the expenditure on goods to be raised in order to re-establish the optimum and in that creating an excess demand in the goods market. In the long run prices and wages are perfectly flexible and in the presence of excess demand, there is a rise in the price level until the excess demand is satisfied, at the new equilibrium.Again this rise in prices leads to an increase in the demand for money and thus leads to a restoration of the real interest rates and investments to their initial leve ls (Patinkin, 1987). Therefore, in the long run money supply increases have no effects on real interest rates, investment, or output in the long run. So, we take place that although money is actually non-neutral in the long run due to the wage-price rigidness in the short run, in the long run money has neutral effects. Infact, Patinkin (1956) notes that not only is money neutral in the short run but this short run neutrality is absolutely necessary for the quantity theory to hold. If this non-neutrality is denied and the classical dichotomy is accepted, then there is no theory of money, quantity theory or otherwise.Testing the neutrality of money would fill one to measure the effects of altered money supply has on real variables like the real GDP, employment and real interest rate. unrivaled approach possible would be to use a time serial publication data set with values for these variables.A regression would be run to ascertain the extent of effects if any, the changes in mone y supply over time has had on the real variables. In fact, Fisher and Seater (1993) have employ time series data in this manner to test the neutrality of money. Their methodology however requires the usage of advanced econometric tools. Many accompanying studies2 have adopted this methodology to test time series data for different regions and check for neutrality of money.Another option would be to use cross section data with different regions specified by different money supply values. By gauging the differences in the values of the real variables of these regions and relating these with the differences in the money supply values through regression analysis can be another way of interrogation for neutrality of money.So, to sum up, we have seen that although short run neutrality of money is not a legal proposition, money does not have real effects in the long run. In the final section we have suggested two possible approaches to testing the neutrality of money.ReferencesAckley, G ., (1978). Macroeconomics Theory and Policy, pertly York MacmillanBoschen, J.F. & Otrok, C.M., (1994) Long run neutrality and superneutrality in anARIMA framework comment, American Economic Review 84, 1470-1473.Carlin, W., & Soskice, D., (1990) Macroeconomics and the Wage Bargain A Modern Approach to Employment, Inflation, and the Exchange Rate, U.K. Oxford University PressFisher, M.E. & Seater, J.J., (1993) Long run neutrality and superneutrality in an ARIMA framework, American Economic Review 83, 402-415.Mankiw, N.G., (2000) macroeconomics 4th ed, Worth publishers, New YorkPatinkin., D. (1987) Neutrality of money, The New Palgrave A Dictionary of Economics, v. 3, pp. 639-4Patinkin, D., (1956) Money, interest and prices An integration of monetary and value theory, New York Row Peterson 1 One should be beware of the tawdry potential of the term classical and note its distinct presence in macroeconomics and its modern adoptions in the forms of new classical economics and thereby d ebar confusing it with the school of economic thought associated with Marx, Smith and Ricardo. 2 e.g., Boschen and Otrok (1994) for the US