Neutrality of Money
Neutrality of Money
The (classical) quantity theory of money represents a central organizing principle for macroeconomic analysis. It goes back hundreds of years, to the writings of David Hume (Hume 1970) and Irving Fisher (Fisher 1922).
The theory posits that one-time permanent shifts in nominal variables have no effect on real variables in the long run. The simplest quantity-theoretic proposition, known as the long-run monetary neutrality proposition, specifies that a permanent, stochastic, (that is, purely random) shock to the money supply has a one for one effect on prices and a zero effect on real output in the long run. Another quantity-theoretic proposition is that of long-run monetary superneutrality, specifying that a permanent change in the rate of growth of nominal money (that is, money measured in current dollar magnitudes) has no long-run effect on the level of real output. In sum, changes in the money supply affect the price level (inflation) but have no effect on relative prices, the volume of employment, output, or real income (purchasing power).
Over the years, the long-run monetary neutrality propositions have been investigated in a large number of studies (McCandless and Weber 1995). However, as Lucas (1996, p. 661) puts it in his Nobel lecture, “so much thought has been devoted to this question [of proving long-run neutrality] and so much evidence is available that one might reasonably assume that it had been solved long ago. But this is not the case.” In fact, Fisher and Seater (1993) and King and Watson (1997), using state-of-the-art advances in the field of applied econometrics, have shown that meaningful long-run neutrality tests can only be constructed if both nominal (measured in current dollar magnitudes) and real (measured in units of commodities) variables satisfy certain nonstationarity conditions (regarding, for example, variance, trends, and seasonal patterns) and that much of the older literature violates these requirements.
In the spirit of Fisher and Seater (1993) and King and Watson (1997), Serletis and Koustas (1998) provide international evidence for the long-run neutrality and superneutrality propositions. Using the eclectic approach of King and Watson (1997) and the Backus and Kehoe (1992) data, consisting of over one hundred years of annual observations on real output and money for ten countries—Australia, Canada, Denmark, Germany, Italy, Japan, Norway, Sweden, the United Kingdom, and the United States—they show that the data are generally supportive of monetary neutrality.
In a similar study testing the long-run neutrality of money and using the King and Watson (1997) methodology, Serletis and Koustas (2001) pay particular attention to the gains that can be achieved by rigorous use of microeconomic- and aggregation-theoretic foundations in the construction of money measures. To address disputes about the relative merits of different monetary aggregation procedures, they make comparisons among simple-sum, Divisia (named after the French economist Francois Divisia), and currency-equivalent money measures for the United States, obtained from the monetary services indices (MSI) database, maintained by the Federal Reserve Bank of St. Louis as a part of the bank’s Federal Reserve Economic Database. The results show that the hypothesis of long-run monetary neutrality finds support in the United States data, irrespective of how money is measured.
Finally, another long-run neutrality proposition is the Fisher relation. According to the Fisher equation, R = r + π, where R is the nominal (dollar) interest rate, r the real interest rate (the rate that determines the growth over time in the real value of assets), and π the inflation rate, the Fisher relation states that the nominal interest rate moves one-for-one with inflation in the long-run, meaning that a permanent change in the rate of inflation has no long-run effect on the level of the real interest rate. The Fisher relation holds in models in which the real interest rate is determined by a relation like the modified golden rule (according to which the marginal product of capital in steady state equals the sum of the rate of time preference and the population growth rate) and therefore does not depend on monetary variables (Sidrauski 1967). It is violated, however, in models in which the Tobin (1965) effect applies; in such models, an increase in the inflation rate results in a decrease of the real interest rate and therefore in a less than one-to-one increase of the nominal interest rate (this is known as the Tobin effect).
Koustas and Serletis (1999) have investigated the Fisherian link between inflation and nominal interest rates using postwar quarterly data for eleven countries—Belgium, Canada, Denmark, France, Germany, Greece, Ireland, Japan, the Netherlands, the United Kingdom, and the United States—and the King and Watson (1997) methodology. Their results are consistent with most of the existing literature on the Fisher effect, which mostly shows that fully anticipated inflation has less than a unit effect on the nominal interest rate, and thus reduces the real interest rate even in the longest of runs. In view of the inability to reject long-run monetary neutrality by examining the effects of money shocks on real output, we are thus left with a puzzle that needs to be addressed by future theoretical and empirical work.
SEE ALSO Economics, Keynesian; Economics, New Classical; Interest Rates; Monetarism; Monetary Theory; Money; Money, Demand for; Policy, Monetary; Quantity Theory of Money
BIBLIOGRAPHY
Backus, David K., and Patrick J. Kehoe. 1992. International Evidence on the Historical Properties of Business Cycles. American Economic Review 82 (4): 864–888.
Fisher, Irving. 1922 The Purchasing Power of Money: Its Determination and Relation to Credit, Interest, and Crises. 2nd ed. New York: Macmillan. Reprint, New York: Augustus Kelley, 1971.
Fisher, Mark E., and John J. Seater. 1993. Long-Run Neutrality and Superneutrality in an ARIMA Framework. American Economic Review 83 (3): 402–415.
Hume, David. 1955. Writings on Economics. Ed. Eugene Rotwein. Madison: University of Wisconsin Press.
King, Robert G., and Mark W. Watson. 1997. Testing Long-Run Neutrality. Federal Reserve Bank of Richmond, Economic Quarterly 83 (3): 69–101.
Koustas, Zisimos, and Apostolos Serletis. 1999. On the Fisher Effect. Journal of Monetary Economics 44 (1): 105–130.
Lucas, Robert E., Jr. 1996. Nobel Lecture: Monetary Neutrality. Journal of Political Economy 104 (4): 661–682.
McCandless, George T., Jr., and Warren E. Weber. 1995. Some Monetary Facts. Federal Reserve Bank of Minneapolis, Quarterly Review 19 (3): 2–11.
Serletis, Apostolos, and Zisimos Koustas. 1998. International Evidence on the Neutrality of Money. Journal of Money, Credit, and Banking 30 (1): 1–25.
Serletis, Apostolos, and Zisimos Koustas. 2001. Monetary Aggregation and the Neutrality of Money. Economic Inquiry 39 (1): 124–138.
Sidrauski, Miguel. 1967. Rational Choice and Patterns of Growth in a Monetary Economy. American Economic Review 57 (2): 534–544.
Tobin, James. 1965. Money and Economic Growth. Econometrica 33 (4): 671–684.
Apostolos Serletis