Question

Define and demonstrate with the AD/AS model the concept of money neutrality.

Answer 1

The neutrality of money, also called neutral money, says changes in the money supply only affect nominal variables and not real variables. This implies that with an increase or decrease in the money supply, the price level will change but output of the economy remains same. An increase in the money supply raises the overall price level by the same percentage, with no effect on real variables—real quantities and relative prices.

In latest versions of money neutrality theory, changes in the money supply might affect output or unemployment levels in the short run only, but neutrality is still assumed in the long run after money circulates throughout the economy.

Consider the IS-LM model of an economy at full employment (as in the attached image). Let the money supply increase by 10%, so LM curve falls. The interest rate drops (point B). The lower interest rate raises the aggregate demand for goods, and the economy lies left of the IS curve.

Demand exceeds product. Product cannot rise, as the economy is already at full employment. Hence the excess demand for goods causes prices to rise. The price rise continues until prices have increased by 10%. As P rises, real money balances M/P fall. The LM curve shifts back up to its original position, and demand equals supply for goods (point A)