On the Neutrality of Money

Neutrality of money has been a central question for monetarism. The most important answers were elaborated within the framework of the Phillips curve. Milton Friedman, assuming adaptive expectations, distinguished a series of short-run Phillips curve and a long-run one, where the short-run curves were supposed to be the conventional, negatively sloped curves, while the long-run curve was actually a vertical line indicating the natural rate of uneployment. According to Friedman, money was not neutral in the short run, because economic agents, confused by the money illusion, always respond to changes in the money supply. If the monetary authority chooses to increase the stock of money and, hence, the price level, agents will be never able to distinguish real and nominal changes, so they will regard the increase in nominal wages as real modifications, so labour supply will also be boosted. However, this change is only temporary, since agents will soon realize the actual state of affairs. As the higher wages were accompanied by higher prices, no real changes in income occurred, that is, it was no need to increase the labour supply. In the end, the economy, after this short detour, will return to the starting point, or in other words, to the natural rate of unemployment.

New classical macroeconomics led by Robert E. Lucas also have had its own Phillips curve. However, things are far more complicated in these models, since rational expectations were presumed. For Lucas, the island models made up the general framework in which the mechanisms underlying the Phillips curve could be scrutinized. The purpose of the first Lucasian island model was to establish a framework to support the understanding of the nature of the relationship between inflation and real economic performance by assuming that this relation offers no trade-off exploitable by economic policy. Lucas’ intention was to prove that the Phillips curve exists without existing. It was a heritage that there is a trade-off between inflation and unemployment or real economic performance, so it is undoubted that there is a short run Phillips curve (or there are short run Phillips curves). Although there are fewer possible actions available for the monetary policy to conceit people in order to increase the labour supply, unexpected changes can always trigger real changes. But what is the ultimate purpose of the central bank when changing the money supply? For example and mostly: exerting countercyclical control. Doing so, monetary policy would increase the money supply in order to eliminate the negative effects of an unfavourable macreconomic shock. However, monetary policy is not able to utilize the trade-off between inflation and real economic performance, because there is no information available in advance about the shocks to eliminate. Under these conditions, the central bank is unable to plan a course of action, that is, a countercyclical monetary policy. Rational agents can be conceited only by unexpected changes, so a well-known economic policy is completely in vain. However, and this is the point, the central bank cannot outline unforseeable interventions, because it has no informational advantage over the agents. The central bank has no information about what to eliminiate through countercyclical actions. The trade-off between inflation and uneployment exists, but it cannot be utilized by the monetary policy for countercyclical purposes.

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