[PDF Notes] Short Essay on the Neutrality of Money

Economists like Wicksteed, Hayek, Robertson, advocated that the main objective of the monetary policy is to maintain complete neutrality of money. The policy of neutrality of money seeks to do away with the disturbing effect of changes in the quantity of money on important economic variables, like income, output, employment and prices.

They cause disturbances in the smooth working of the economic system. They are responsible for the occurrence of trade cycles. They bring changes in the real variables like income, output, employment and relative prices. They cause imbalance between demand and supply, consumption and production.

Thus, economic fluctuations (inflation and deflation) are the result of non-neutral money (involving changes in money supply) and stability in the economic system with no inflation and deflation requires the adoption of neutral money policy (involving constant money supply).

Thus, according to the policy of neutral money, if the money is made neutral and the money supply is kept constant, there will be no disturbances in the economic system.

In such a situation, relative prices will change according to the changes in the demand and supply of goods and services, economic resources will be allocated according to the wants of the society, and there will be no inflation and deflation. However, this does not mean that the money supply should be kept constant under all circumstances:

(i) The supply of money will have to be changed from time to time to provide for the changes in the velocity of money; in the periods of a fall in the velocity of money, the supply of money has to be increased and in periods of a rise in the velocity of money, the supply of money has to be reduced.

It is, in fact, the volume of effective money supply (including both the volume of standard and bank money as well as the velocity of circulation of the money) which should be kept constant.

(ii) The money supply will also be changed to neutralise the basic changes in the economic structure of the country. Such basic changes are changes in population, changes in the techniques of production, innovations, etc.

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