Money is Non-neutral - J. Robert Subrick
neutral money: changes in the money supply do not alter relative prices
they only influence the aggregate price level
accepted macroeconomically in the long run
Changes in the money supply alter only the level of nominal variables.
non-neutral money: increases in the money supply do affect relative prices and real variables in the short run
a central pillar for explaining the austrian business cycle
Changes in the supply of money affect the market rate of interest, altering savings and investment patterns.
austrian business cycle:
the monetary authority increases the money supply → interest rate falls
relative prices change between consumption and investment goods.
investment increases, but not backed by real savings.
differences emerge between the amount and types of goods produced and the types of goods demanded.
malinvestment occurs when certain markets have excess supply and others excess demand.
The downturn happens once this divergence becomes too great.
keynes: "in the long run we are all dead"
referring to the irrelevance of the long-run monetary neutrality proposition discussed by proponents of the quantity theory of money.
What is neutral money?
neoclassical definition: emphasis in the long run. when a change in the money supply only affects the price level and not real variables.
Formally, it refers to a demand function that is homogeneous of degree zero in money prices and the initial quantity of financial assets.
propositions that describe neutral money:
Money acts only as a veil: the introduction of money does not affect resource allocation and the economy acts as if it were a barter economy.
Hayek described this as the conditions under which relative prices are formed as if they were influenced only by 'real' factors.
money only provides a scalar to facilitate exchange by reducing transaction costs.
This definition was considered a policy ideal unlikely to be attained in the modern world.
Monetary equilibrium holds at all times: no excess demand or supply of money exists.
Individuals hold their optimum quantity of money based on their subjective expectations.
The Austrian tradition has focused more thoroughly on the impact of monetary disequilibrium.
When new money is introduced into the system, prices change as the new recipients use their money to purchase goods.
The resulting price rise forces others to change the amount of money they hold for consumption.
Changes in productivity also cause monetary disequilibrium
increased productivity reduces prices, leading individuals to demand less money
Changes in the money supply only affect the aggregate price level as described in the quantity theory of money.
Equation of exchange: MV=PQ
M = money supply
V = velocity of money
P = general price level
Q = quantity of output
money has a neutral effect when V and Q are held constant.
changes in M only affect P.
Hayek dismissed the quantity theory as relatively useless because its magnitudes do not influence the decisions of individuals.
The neutrality proposition here only addresses long-run properties and does not explain the process of how prices change as the economy shifts between equilibria.
The new money is not distributed equally in the modern economy, unlike the famous helicopter analogy, causing non-neutral effects.
Changes in the rate of inflation do not affect real variables: super-neutrality proposition.
Changes in the growth rate of the money supply may still affect the real economy.
inflation has distributional effects.
the wealthy can adjust their portfolio to assets less affected by inflation more easily than the poor.
Changes in the variance in inflation can affect economic growth by increasing uncertainty.
When investors cannot predict future inflation rates due to instability, investment falls, reducing the rate of economic growth.
Conventional macroeconomic wisdom suggests money is neutral in the long run.
However, empirical studies do find non-neutral effects when examining the short run.
Sources of non-neutrality
Hayek offered several reasons in the 1930s for non-neutrality:
Cantillon effects: when the money supply is increased, the money ends up in the hands of some.
The path by which money enters the economy is emphasized.
The initial recipients have increased purchasing power relative to the rest of the citizenry.
that money is spent on the goods they prefer, so the price for those goods increase.
higher price leads to resource reallocation as firms respond to higher prices.
The process alters the structure of relative prices.
by the time money becomes neutral in the long run, a new distribution of prices has emerged.
The effect arises because citizens lack relevant information, confusing real and nominal changes.
Forced savings:
Hayek developed this idea to explain how money supply changes affect relative prices between consumption and capital investment.
When the money supply increases, capital formation increases due to a reduction in the interest rate.
Subsequent inflation forces people with fixed incomes to use their existing savings because the savings have lost purchasing power.
This is defined as the forced reduction in the purchasing power of non-recipients of excess supplies of money.
Money illusion: people do not understand the difference between real and nominal variables.
If money illusion is absent, only changes in real variables (like economic growth) affect behavior.
Standard microeconomic theory supports the absence of money illusion.
The Austrian approach does allow for money illusion, noting that confusion between nominal and real changes "plagues people".
Money illusion can serve as a source of price stickiness.
A major explanation for money illusion is the costs of obtaining information.
If nominal prices change slowly, people have little incentive to collect information about inflation-adjusted prices.
An alternative Austrian explanation, based on Hayek’s The Sensory Order, suggests that because people operate within an environment of nominal prices, their perceptions evolve, causing them to think in nominal terms.
Sticky prices and long-term contracts: for money to have neutral effects, wages and prices must adjust immediately to changing demand and supply conditions.
Long-term contracting limits the neutrality of money in the short run.
individuals negotiate contracts in order to minimize uncertainty by guessing future prices.
when they guess wrong about the future, money has non-neutral effects.
Example: Wage contracts are nominal; if actual inflation exceeds expected inflation, the real wage falls.
New Keynesian models extended these sources, including menu costs.
Menu costs occur when the cost of updating prices (e.g., printing new menus) outweighs the benefits, especially if price changes are small.
Mundell-Tobin effect:
Occurs when nominal interest rates increase less than proportionally with inflation.
Increased inflation reduces the value of money, leading consumers to hold less money and switch to other assets.
The resulting increased demand for other assets causes real interest rates to fall.
The change in the rate of inflation thereby causes real changes in the economy.
Commodity money:
When money has a commodity basis (like gold), it inherently has non-neutral effects.
An increase in the commodity supply increases the price level and changes relative prices between the commodity and other goods.
Since the breakdown of the Bretton Woods system, the use of fiat money has largely removed commodity money as a source of non-neutrality in developed nations.
Non-neutral money and economic fluctuations
The Austrian explanation stresses how monetary factors cause real changes that increase and decrease GDP in the short run.
Money exerts a large effect on the aggregate economy and is a source of the business cycle.
The theory begins with the natural rate of interest:
This rate reflects the subjective preferences of those who save and those who borrow.
It is "natural" because it reflects the preferences and constraints of economic actors, assuming intertemporal preferences do not change.
The fluctuation mechanism:
The central bank expands the money supply, increasing the supply of credit.
The market rate of interest declines, falling below the natural rate.
Investment rises and saving falls at this lower market rate.
The Austrian approach focuses on how the credit injection affects the capital structure.
The initial recipients of the new money (often banks or the central government via bond purchases) have increased purchasing power.
The non-neutral effects stem from money acting as a loose joint that permeates all markets, forcing people to adjust their money holdings.
In monetary disequilibrium, there is a mismatch between savings and investment.
This lack of synchronization between signals facing entrepreneurs and preferences of consumers creates an unsustainable capital structure that must eventually be reversed.
Money is non-neutral when expected relative price changes lead to the reallocation of resources to activities they would otherwise avoid.
The New Classical challenge
The rise of the New Classical approach significantly reduced the importance of money in macroeconomics.
Early models assumed away sources of non-neutrality:
They posit instantaneous price adjustment to money supply changes, making neutrality the norm.
They assumed away money illusion, distributional concerns, and systematically incorrect expectations.
Challenge to Causality:
New Classical theorists argue that causation runs opposite to the Austrian view.
They claim changes in output cause changes in the money supply.
Example: Economic expansion raises money demand, prompting the monetary authority to increase the money supply (output causes monetary expansion).
Rational Expectations Hypothesis (REH):
States that individuals form expectations rationally, optimizing the costs and benefits of collecting information.
Implies that people do not make systematic mistakes, as systematic errors are costly and expectations are continually updated.
Individuals with REH assume they have a correct theory of the economy and understand that money affects only nominal variables.
Austrian responses:
Austrian models have offered plausible, empirically supported explanations for sticky prices.
Regarding the causal direction of money and output, little direct Austrian research has addressed this claim.
Regarding REH, Austrians note that agents must use all available information, including probable consequences of government policies.
However, arguing that systematic policies are ineffective even in the short-run remains unacceptable.
Irony of the challenge: Early New Classical models, like the Lucas island model, explicitly accepted the non-neutrality of money and were built on Hayek’s ideas.
Real business cycle models also began with an Austrian notion: Eugen von Bohm-Bawerk’s concept of capital as a time-consuming process.
Conclusions
Non-neutrality of money is the basis of Austrian claims regarding money's role in a dynamic economy.
Money acts as a loose joint in the economic system, permeating all formal markets.
When the money market is out of equilibrium, all markets are affected as people adjust their cash balances.
Despite non-neutrality being a cornerstone of the Austrian approach since the 1930s, relatively little subsequent Austrian research has focused on the sources of non-neutrality (New Keynesians conducted much of this work).
Integrating the effects of non-super-neutral money remains an important area for future inquiry.
This could offer new insights into how changes in the growth rate of the money supply affect the evolution of economies over decades.
The emergence of interest in Hayek’s psychological writings offers an opportunity to reassess Austrian monetary theory, especially considering the limited capabilities of economic agents to understand all interdependencies of a modern economy.