Chapter 53: Non-neutrality of Money
He-Ling Shi INTRODUCTION In economics, Non-neutrality of money is the idea that a change in the stock of money affects not only nominal variables in the economy such as prices, but also has effects on real variables like employment, consumption and real GDP. It is an important departure from the classical dichotomy – which holds that money supply will only affect nominal variables. Nonneutrality of money implies that the monetary authority (for example, central bank) can affect the real economy (for example, the number of jobs, the size of the GDP, the amount of investment) by changing money supply. Non-neutrality also explains, contrary to the traditional neutrality thesis, why a financial crisis could happen. The idea of Non-neutrality of money can be traced back to Keynes (1936), and its modern incarnation has been collectively called New Keynesian Economics (Mankiw and Romer, 1991), which strives to provide microeconomic foundations for Keynesian economics. A variety of market imperfection has been introduced to produce Keynesian macroeconomic effects. Central to this literature is the microfoundation of price stickiness and the assumption of monopolistic competition. A commonly used explanation of why prices adjust slowly, along with the price stickiness approach, is ‘menu costs’ (Mankiw, 1985). This idea is that the reason firms do not change their prices immediately is the costs that they must incur in order to do so – for example, the cost of making a new catalog, price list and so on. Price stickiness is also present in the labor market in the form...
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