The Long-Run Neutrality of Money: Theoretical Foundations and Empirical Evidence

Abstract. One of the most important theories around which the field of monetary economics has centred upon, has been the theory of neutrality of money. According to this theory, money has no real effect on how resources are allocated in an economy in the long run. The paper expounds on the evolution of this theory since the 17th century, explores the theoretical foundations behind the proposition and reviews the empirical evidence in the field with an aim to synthesise the literature. While modern versions of the theory accept that changes in the growth rate of the money stock might affect output in the short run, we lack a clear answer to whether they are also non-neutral in the long run. Non-neutrality in the long run may be attributed to the effect of changing prices on the demand for money balances, and the effect of money creation on interest rates. However, if there are no lagged adjustments, expectations are perfect, the banking system is perfectly competitive and redistributive effects of government expenditures are ignored, money will be neutral. The empirical evidence for long run neutrality is mixed from the perspectives of the performance of broad and narrow monetary aggregates as well as the analysed countries, highlighting the need for more studies in this field. There nonetheless remains a consensus on the short-run effectiveness of the use of monetary policy.

Keywords: Long-Run Neutrality of Money, Monetary Policy, Quantity Theory of Money