The phrase neutrality of money refers to an economic theory that changes in the supply of money do not primarily impact the actual variables of an economy, such as the rate of employment or the gross domestic production (GDP). As a concept, neutrality of money has been a tenet of classical economics since the 1920s. When money is introduced into an economic system, prices and wages rise proportionately, but the overall supply and demand for goods and services remains unchanged, theoretically. Although neutrality of money holds true over long periods of time within an economic system, the disequilibrium produced in an economy by rapid increases or decreases in the money supply does lead to short-term changes in employment, production, and consumption. New Keynesian economic models discard the neutrality of money, pointing out the significant impact on real economic variables that credit and debt can have.
Long-term economic cycles reflect neutrality of money, but in the short-term, infusions or subtractions of money produce changes in the employment level, production of goods, and consumer behavior. For example, an oversupply of money may increase demand for goods and services and encourage more spending. Since demand outstrips supply, prices increase. Companies may then increase production and hire more employees to meet demand. Finally, the system arrives at a new equilibrium, where supply and demand balance each other.
The quantity theory of money states that there is a proportional relationship between prices and the money supply. According to the Fisher equation, the quantity theory of money (QTM) states that as the money supply and the velocity of money increase, prices and transactional volumes also increase. Based on this theory, monetarists advocate that the money supply be controlled within a narrow range to balance the conflicting goals of stimulating the economy and controlling inflation. Most monetarists favor a gradual reduction in the money supply over time to achieve an initial bump in productivity followed by the deflationary effects of monetary contraction.
Although short-term influences of money supply changes do cause changes in real economic variables, price and wage stickiness can undermine these effects. For example, even when the United States Federal Reserve prints more money, prices and wages may not increase due to a variety of factors. Contractions of the money supply are not always accompanied by decreases in wages and prices. Wage and price stickiness complicate the decision-making process of the Federal Reserve with respect to any interventions that it might make in order to stimulate the economy.