The Fallacy of Monetary Neutrality

Referring to a recent post by Scott Sumner, in NGDP Targeting: Altering Theory to Fit History I asked:

What happened to the causal effect whereby a “decline in nominal GDP brought about a sharp decline in real GDP”?

Underlying this question appears to be a deeper one regarding the potential neutrality of money. Accepting that money is neutral implies that changes in the quantity of money can alter real GDP in the short-run, but in the long-run has no real impact (only nominal). It is through assumptions such as this that economists believe they can ignore money and the financial system in macroeconomic models of the economy.

Nick Rowe attempts to establish the neutrality of money, to which David Glasner responds that Money Is Always* and Everywhere* Non-Neutral. Glasner’s thoughtful insight is well-worth reading in full, but the conclusion is that:

every economic equilibrium is dependent on the expectations held by the agents. A change in expectations changes the equilibrium. Or, as I have expressed it previously, expectations are fundamental. If a change in monetary policy induces, or is associated with, a change in expectations, the economic equilibrium changes. So money can’t be neutral. Ever.

Changes in the supply of money do have causal effects on real GDP, even in the long-run. Incorporating money and credit into models of the economy is therefore imperative to improving forecasting and better informing policy making.