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If a central bank carried out monetary policy that consisted of multiplying each person's wealth by a common factor, I would find it plausible that all prices would get multiplied by the same factor and there would be approximately no real effects.

However, this is not how central banks carry out monetary policy. They print money and engage in market transactions that target certain prices. To me it does not seem plausible that this has no real effects, in the long run or the short run.

My question is, why do many economists believe that money is neutral in the long run? Do they take the quantity theory of money as proof that money is neutral in the long run? Is there particular empirical evidence, or influential papers that have convinced many economists that money is neutral in the long run?

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There are multiple ways that a central bank can resort to apply its designated monetary policy. The most common one is called "open market operations (omo)", which is basically selling/buying government securities to/from private individuals or organizations. Through these operations, central bank affects the level of cash reserves in the banking system since it deposits/withdraws payments for these government securities to/from the banking system. When cash reserves in the banks go up -by central bank buying government securities-, these banks decrease their interest rate to deplete the extra added cash reserves, and the vice-versa.

As you can see, in this mechanism the only price that is changed "directly" by central bank is the price of government securities. Once the cash reserves in the banking system reaches its targeted level, the probability that the general price level in a specific market will be affected is equal for almost all markets. Thus the operations of central bank does not aim at specific markets, alterations in the interest rates affect the whole economy equally by average.

There are tons of literature, both theoretical and empirical, focusing on the neutrality of money. You can also search them via Google Scholars.

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  • $\begingroup$ "Once the cash reserves in the banking system reaches its targeted level, the probability that the general price level in a specific market will be affected is equal for almost all markets." - is that really true though? Is there good empirical evidence for this? And even if the probability of the price in any one market being affected is the same across all markets, which I don't think is true btw, does monetary policy consistently have the effect of multiplying the price in every single market by a common factor? In that case Id put some truck in money neutrality. But I don't think its true. $\endgroup$ – Steven Jul 23 '18 at 8:56
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If one believes that there is a single equilibrium, and that markets will find it whatever the starting position, then money must be neutral in the long run. A monetary intervention, in that world, is a temporary perturbation that will get traded away to zero eventual impact, as everything returns to equilibrium.

It is likely that neither of those underlying assumptions are true.

However, they are commonly made to simplify the analysis.

Some economists fall into the trap of making the assumptions to simplify the analysis, but then internalising those assumptions as being how the world actually works.

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I'm more of a micro guy, so take what I'm saying with a grain of salt.

Suppose there's a monetary policy shock. Because of nominal rigidities and credit market imperfections output, prices change. The price level eventually settles in its trajectory and output does the same.

I guess what I'm trying to do is to ask you a question: how can money not neutral? How can a Central Bank change, only through policy, in the longo run?

It that were the case, wouldn't every single country in the world be rich by now?

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  • $\begingroup$ Do you mean how can money not be neutral in the long run? If the central bank engages in some market transactions, this inevitably changes prices in the economy, and this clearly has real effects - people do not buy the same stuff as they did before. I struggle to see how monetary policy couldn't have real effects in the long run. $\endgroup$ – Steven Jul 22 '18 at 21:11

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