Question

Explain the logic of the monetary neutrality and why changes in the quantity of money only affect nominal variables and not real variables. Do you agree that monetary neutrality approximates the behavior of the economy in the long run? Why or why not?

Answer 1

Neutrality of Money
The neutrality of money in economics says the changes in the stock of money or money supply would only affect the nominal variables and not the real ones. Nominal variables are accounted in current prices and real variables in actual price or related to a base price. Nominal variables would include price, wages and exchange rates etc. where real variables including GDP, employment and level of consumption etc. The increased supply of money cannot increase the supply of goods and services alone. That may only tends to inflation leading price increase. The same quantity of goods existing in the market will be demanded by the increased amount of money. So, only price wages etc. are affected, not the actual level of real variables. The real variables could change only when the real supply or demand increased with increase in the level of consumption. Increased supply of money could mostly follow the same old level of consumption with increased price for goods and inputs for production.
Most of the economists believed that the neutrality of money could only help in long run but not in short run. It is because they believed the increased price would helps in increasing the supply in the long run thus increasing the demand further. But there are modern economists who believe that the neutrality of money can even affect the short run by affecting the real variables. So, even there are differences in the analysis of neutrality of money among economists, it is known that the change in supply cannot affect the real variables mostly because there is not a real change in the actual output in the economy.