When we study macroeconomic theory we are that we are taught about “money neutrality”. Normally money neutrality is seen as a certain feature of a given model. In traditional monetarist models monetary policy is said to be neutral in the long run, but not in the short run, while in Real Business Cycle (RBC) models money is (normally) said to be neutral in both the long and the short run. In that sense “money neutrality” can be said to be a positive (rather than as normative) concept, which mostly is dependent on the assumptions in the models about degree of price and wage rigidity.

As a positive concept money is said to be neutral when changes in the money supply only impacts nominal variables such as prices, nominal GDP, wages and the exchange rates, but has no real variables such are real GDP and employment. However, I would suggest a different interpretation of money neutrality and that is as a normative concept.

Monetary policy should ensure money neutrality

Normally the discussion of money neutrality completely disregard the model assumptions about the monetary policy rule. However, in my view the assumption about the monetary policy rule is crucial to whether money is neutral or not.

Hayek already discussed this in classic book on business cycle theory Prices and Production in 1931 – I quote here from Greg Ransom’s excellent blog “Taking Hayek Serious”:

“In order to preserve, in a money economy, the tendencies towards a stage of equilibrium which are described by general economic theory, it would be necessary to secure the existence of all the conditions, which the theory of neutral money has to establish. It is however very probable that this is practically impossible. It will be necessary to take into account the fact that the existence of a generally used medium of exchange will always lead to the existence of long-term contracts in terms of this medium of exchange, which will have been concluded in the expectation of a certain future price level. It may further be necessary to take into account the fact that many other prices possess a considerable degree of rigidity and will be particularly difficult to reduce. All these ” frictions” which obstruct the smooth adaptation of the price system to changed conditions, which would be necessary if the money supply were to be kept neutral, are of course of the greatest importance for all practical problems of monetary policy. And it may be necessary to seek for a compromise between two aims which can be realized only alternatively: the greatest possible realization of the forces working toward a state of equilibrium, and the avoidance of excessive frictional resistance.  But it is important to realize fully that in this case the elimination of the active influence of money [on all relative prices, the time structure of production, and the relations between production, consumption, savings and investment], has ceased to be the only, or even a fully realizable, purpose of monetary policy. ”

The true relationship between the theoretical concept of neutral money, and the practical ideal of monetary policy is, therefore, that the former provides one criterion for judging the latter; the degree to which a concrete system approaches the condition of neutrality is one and perhaps the most important, but not the only criterion by which one has to judge the appropriateness of a given course of policy. It is quite conceivable that a distortion of relative prices and a misdirection of production by monetary influences could only be avoided if, firstly, the total money stream remained constant, and secondly, all prices were completely flexible, and, thirdly, all long term contracts were based on a correct anticipation of future price movements. This would mean that, if the second and third conditions are not given, the ideal could not be realized by any kind of monetary policy.”

Hence according to Hayek monetary policy should ensure monetary neutrality, which is “a stage of equilibrium which are described by general economic theory”. In Prices and Production Hayek describes this in terms of a Walrasian general equilibrium. Therefore, the monetary policy should not distort relative prices and hence monetary policy should be conducted in a way to ensure that relative prices are as close as possible to what they would have been in a world with no money and no frictions – the Walrasian economy.

As I have discussed in a numerous posts before such a policy is NGDP level targeting. See for example here, here and here.

And this is why the RBC model worked fine during the Great Moderation

If we instead think of monetary policy as a normative concept then it so much more obvious why monetary policy suddenly has become so central in all macroeconomic discussions the last four years and why it did not seem to play any role during the Great Moderation.

Hence, during the Great Moderation US monetary policy was conducted as if the Federal Reserve had an NGDP level targeting. That – broadly speaking – ensured money neutrality and as a consequence the US economy resembled the Walrasian ideal. In this world real GDP would more or less move up and down with productivity shocks and other supply shocks and the prices level would move inversely to these shocks. This pretty much is the Real Business Cycle model. This model is a very useful model when the central bank gets it right, but the when the central bank fails the RBC is pretty useless.

Since 2008 monetary policy has no longer followed ensured nominal stability and as a result we have moved away from the Walrasian ideal and today the US economy therefore better can be described as something that resembles a traditional monetarist model, where money is no longer neutral. What have changed is not the structures of the US economy or the degree of rigidities in the US product and labour markets, but rather the fed’s conduct of monetary policy.

This also illustrates why the causality seemed to be running from prices and NGDP to money during the Great Moderation, but now the causality seem to have become (traditional) monetarist again and money supply data once again seems to be an useful indicator of future changes in NGDP and prices.