What is Neutrality of Money?
The neutrality of money is a theory stating that changes in the money supply only affect prices and wages rather than overall economic productivity.
How Does Neutrality of Money Work?
For example, when the Federal Open Market Committee (an agency within the Federal Reserve) purchases U.S. Treasurys in the open market, it gives money to the sellers. The sellers deposit these payments at their local banks. Because the Federal Reserve requires banks to maintain a certain percentage of these deposits in reserve, the banks are free to lend most of these new deposits to other bank customers and earn interest. These customers in turn deposit the loan proceeds in their own bank accounts, and the process continues indefinitely. Thus, every dollar of securities that the Federal Reserve buys increases the money supply by several dollars.
There are only two things to do with money: save it or spend it. Accordingly, some of the 'new' money in the economy (from the Treasury repurchase) will land in bank accounts, and some of the new money will land in the hands of retailers, service providers, new employees, etc. This increase in the demand for goods and services will drive the prices of those goods and services up. The increased demand may also encourage employers to hire more employees, and the demand for more employees also drives wages up.
However, the neutrality of money theory says that the ripple effect essentially stops there. In other words, the repurchase would not increase the productivity of the economy's employees and may not increase the country's gross domestic product (GDP).
Why Does Neutrality of Money Matter?
The theory of the neutrality of money argues that money is a 'neutral' factor that has no real effect on economic equilibrium. Monetary supply may be able to change how much things cost, says the theory, but it can't change the fundamental nature of the economy itself. The theory is a component of classical economics, but it has less relevance and more controversy today. In particular, some economists argue that the theory really only 'works' over the long term, if at all.