Discussion on the 'neutrality of money' Essay Example | Topics and Well Written Essays - 2000 words

Discussion on the 'neutrality of money' - Essay Example Most schools agree on the long term neutrality of money, and the short term non-neutrality due to stickiness of wages among other factors. However, the schools differ in their theories of money and variables and policies that affect money demand and supply and other macroeconomic variables. Quantity theory of money The classical school of economists developed the quantity theory of money, which basically meant that the price level in the economy is dependent on the money supply. According to this theory inflation is caused by an increase in money supply. According to the theory that national income equals national expenditure the equation of the quantity theory is MV=PY, with V being the velocity of circulation, meaning the number of times in a year a unit of money is spent on buying goods and services, M being money supply, P being the price level and Y the national income. Classical economists through this theory asserted the neutrality of money by claiming that Y and V are exogeno us factors and unaffected by the money supply with V being constant, thus P and M are directly related and changes in money supply would only affect the prices and not output. (Sloman, 1999) Keynes (1936) rejected the quantity theory of money by asserting that a rise in money supply may not necessarily lead to a rise in the price level. This may be due to the fact that the entire increase in money supply may not be spent and may just stay in bank accounts. The Keynesians claim the velocity of circulation is inversely proportional to M and thus the V in the equation may not be a constant. An increase in money supply may lead to an increase in output if there are unemployed resources in the economy. Thus an increase in the money supply can lead to an increase in Y, provided that the economy is not at full employment and not increase prices greatly. Similarly, a decrease in money supply could lead to a decrease in output and thus income causing a decrease in Y. According to Keynes, dem and creates supply and not the other way round, which the Classical school believed. (Graham Sahaw, 1997) Milton Freidman was one of the most vociferous critics of the Keynesians, and brought back the quantity theory of money. According to him, inflation was anywhere and everywhere a monetary phenomenon based on his historical research. According to monetarists, any increase in money supply faster than an increase in output will lead to an increase in inflation. They asserted that V and Y are independent of the money supply and thus money supply will only affect prices and not income or velocity. According to the monetarists, an increase in money supply will increase prices along with employment and output in the short run, but as the economy adjusts to new prices and wages, in a couple of years output and income will adjust downward and the real effect of the increase in money supply will be inflation and vice versa with a decrease in money supply. (D.Mizen, 2000) The new classical theorists put forth the theory of rational expectations, which asserts that markets clear quickly and expectations adjust instantly to market changes. This theory assumes that people are aware of economic conditions and adjust their expectations accordingly. Thus, money is neutral in the short term as well as the long term, as expanding money supply will automatically lead to higher expectations of inflation and in turn