Monetary Neutrality
According to classical macroeconomic theory, monetary neutrality means that changes in the money supply affect nominal variables but not real variables. In other words, if the money supply changes, real variables such as output and employment remain unaffected.
Consequences of Monetary Neutrality
As a result of assuming monetary neutrality, it is possible to analyze the determinants of real variables like real GDP and unemployment without considering variations in the money supply. This implies that the money supply has no influence on real variables but does affect nominal ones. For example, if the money supply were to double, meaning the amount of money available in the economy increased, all prices would also double, including wages. Therefore, the variables that truly matter, like unemployment or purchasing power, would remain unchanged.
Short Term, Long Term, and Monetary Neutrality
In modern macroeconomic theory, most economists agree that monetary neutrality applies in the long run. That is, in the long term, the money supply does not affect real variables such as output, employment, or real wages. However, this is not the case in the short term. In other words, a change in the money supply does impact real variables like output and unemployment in the short run, but over time this effect fades, leaving only an impact on nominal variables. The reason is that, in the short term, prices exhibit rigidities and difficulties in adjusting properly, for various reasons—mainly that many prices are fixed by contracts for a period of time and that there are costs associated with updating prices. Nevertheless, in the long run, prices eventually adjust correctly.