Can monetary policy affect potential output growth? And if yes, how is this consistent with the neoclassical thesis's of money neutrality in the long run?


Can monetary policy affect potential output growth?

Yes. Otherwise, central banks would be indifferent to quantitative easing and other measures.

how is this consistent with the neoclassical thesis's of money neutrality in the long run?

It is not. The premise that "new money neither creates nor destroys machines" sounds accurate only in isolation. But in the real world, companies bind themselves to financial (as well as fiscal) obligations which are in terms of nominal variables.

Certain monetary policies may render those companies cash-strapped, thereby triggering liquidity crises, bankruptcies, higher cost of financing, emigration of skilled workforce, and other effects. Altogether, this may result in structural changes in the economy.

Thus, while the thesis assumes that the aggregate supply curve is vertical, it misses the logical notion that this curve may shift to the left or to the right in the long run.

  • $\begingroup$ This is not accurate. Because we need to differentiate between the short run, where rigidities occur leading monetary policy to affect real variables. Therefore, money is not neutral in the short run. On the other hand, in the long run, the economy converge to steady state and prices/wages fully adjust leading monetary policy to only affect prices in the long run. $\endgroup$ – Ramy Oraby Mar 15 '19 at 10:05
  • $\begingroup$ In that sense, monetary policy only reduce the deviation from equilibrium values leading to less severe cycles and to macroeconomic stability. $\endgroup$ – Ramy Oraby Mar 15 '19 at 10:06
  • $\begingroup$ Empirically, if money is not neutral in the long run, how would you explain the subdued potential output growth in advanced economies despite the unprecedented monetary policy easing? $\endgroup$ – Ramy Oraby Mar 15 '19 at 10:06
  • $\begingroup$ @RamyOraby By assuming a "convergence to steady state" you seem to have a preconceived answer to your own question, but it ignores the realistic, possible effects I outlined (defaults, bankruptcies, emigration, etc) which can affect the long term composition of an economy. Quantitative Easing policies cannot secure effectiveness in preventing the new money from flocking to foreign, financial, and commodity markets (instead of staying in the real economy). And without QE, the number, severity, and speed of bankruptcies would have been much greater than they were in/upon the Great Recession. $\endgroup$ – Iñaki Viggers Mar 15 '19 at 12:57

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