Monday, August 24, 2009

Neutrality of Money

The issue of neutrality or non-neutrality of money has an important bearing on the question of effectiveness or other wise of monetary policy. The supporters of neutrality of money say that a change in the quantity of money may generate economic fluctuations. It is held that creation of money may generate prosperity. The classical economists regarded money as neutral and a viel. It is regarded as simply a medium of exchange and not affecting output and employment in any manner. But to Keynes it was no longer a viel money affects rate of interest and through it rate of investment and hence general economic activity in the county.

Money is regarded as neutral if a change in the quantity of money does not alter the real equilibrium of the economic system. That is the relative prices and interest rates are not affected by a change in the quantity of money.

Conditions for Neutrality:

i. Existence of only one kid of money i.e. either inside money created against private debt and constituted by claims against financial institute or out side money (backed by foreign and government securities).

ii. Absence of money illusion

iii. Absence of distribution effects.

iv. Price wage flexibility.

v. Absence of open market operations.

vi. Unitary elasticity of expectations.

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