Is money — really — neutral in the long run?

22 Jan, 2019 at 22:27 | Posted in Economics | 9 Comments

Paul Krugman has repeatedly over the years argued that we should continue to use neoclassical hobby horses like IS-LM and Aggregate Supply-Aggregate Demand models. Here’s one example:

So why do AS-AD? … We do want, somewhere along the way, to get across the notion of the self-correcting economy, the notion that in the long run, we may all be dead, but that we also have a tendency to return to full employment via price flexibility. Or to put it differently, you do want somehow to make clear the notion (which even fairly Keynesian guys like me share) that money is neutral in the long run.

I doubt that Keynes would have been impressed by having his theory being characterized by catchwords like “tendency to return to full employment” and “money is neutral in the long run.”


One of Keynes’s central tenets — in clear contradistinction to the beliefs of mainstream economists — is that there is no strong automatic tendency for economies to move toward full employment levels in monetary economies.

Money doesn’t matter in mainstream macroeconomic models. But in the real world in which we happen to live, money does certainly matter. Money is not neutral and money matters in both the short run and the long run:

The theory which I desiderate would deal … with an economy in which money plays a part of its own and affects motives and decisions, and is, in short, one of the operative factors in the situation, so that the course of events cannot be predicted in either the long period or in the short, without a knowledge of the behaviour of money between the first state and the last. And it is this which we ought to mean when we speak of a monetary economy.

J. M. Keynes A monetary theory of production (1933)


  1. Serious research into why and how things happen involves going to the archives and drawing material from primary and secondary sources. Then you have to put the pieces together from the ground up – every time.

    Toys, gimmicks and gadgets like ISLM, rational agent models or econometrics can never be a substitute for this. They have been a costly distraction. It would be funny if it wasn’t a tragedy.

    • You have to bring an analysis, and put that analysis together with values specific to the context and circumstances, including observable quantities of the parameters and variables identified in your analysis. The analysis – the logic of the system – has to be worked out in an important sense a priori, but applied practically to a specific context of measured quantities.
      What is indefensible in Krugman’s approach is that he thinks he never has to bring his logic to bear on the specific structures and institutions of a particular economy in order to make a true statement about what is. He squeezes some “insight” from his armchair musings and he thinks that justifies an assertion about the state of the world.
      Sadly, the quality of his analysis itself suffers greatly from his failure to appreciate the necessity of confronting factual specifics.
      Whether a specific economy has any “self-correcting” institutional features and whether those features will prevail in particular circumstances are practical and therefore empirical and factual questions. The researcher or informed observer must go and look to form a sound judgement of reality. This Krugman shows no inclination to do.
      Not realizing that the specifics of institutional context matter to the case, of necessity, Krugman impoverishes the quality of his own thinking. AS-AD is a remarkably stupid idea, but to realize just how stupid, one has to at least imagine trying to apply it: trying to “aggregate” multiple demand and supply schedules for rival and substitute goods alongside a “price level”. Constructing a supply or demand schedule for a single good is highly dubious as there is nothing much to observe except at their intersection in transaction prices — everything else is counterfactual speculation at best; lumping all such schedules together and all prices together as well — that is idiocy! Which Krugman himself would be forced to realize if he ever stepped out-of-doors and looked to see if he could construct such a herd of unicorns with fairy wranglers.
      Asserting the long-run neutrality of money a priori is a symptom of the same conceptual disease. The notion can be traced to Hume’s insight to the effect that the magnitude of the monetary unit of account can not matter. That pound sterling might be worth five times a dollar and a dollar five times a franc can be of no practical importance in the operation of an economic system. Hume tied this insight to the quantity of specie (coin), and a money conceived of as anchored to precious-metal tokens, which led him to endorse a quantity theory of money where the number of tokens available relative to the volume of transactions requiring such tokens to complete loosely regulated the general price level. Stripped from the bounds of this obsolete system of thought, what Krugman calls the long-run neutrality of money is really little more than Hume’s insight that the magnitude of the unit of account is fundamentally arbitrary, which I suppose it is in some completely inconsequential sense. The practical power of money is as a bridge thru time, a way of calculating on promises made and kept (or not); tokens in exchange are mere currency the supply of which is inconsequential as long as it is ample enough to accommodate economic activity. Money on the other hand marks the sequence of events indelibly as time passes and promises and expectations are realized in concrete terms. Such a path dependent course makes nonsense of any claim for the long-run: money’s effects, like history, are one damn thing after another never to be erased. Money, any sane person, would concede is anything but neutral in the short-run and the long-run can only be an accumulation of such short-run effects, without any metaphysical elasticity erasing the past.

      • “What is indefensible in Krugman’s approach is that he thinks he never has to bring his logic to bear on the specific structures and institutions of a particular economy in order to make a true statement about what is. He squeezes some “insight” from his armchair musings and he thinks that justifies an assertion about the state of the world.”

        This is indeed the problem. And this is exactly what he does in his liquidity trap article on Japan. The causes of low interest rates and low growth and the mismatch of savings and investment in Japan requires an understanding of fundamental things about Japanese capitalism. For example how a system that was designed to achieve very high growth after WWII very quickly became unstuck by deregulation and other events from the 1970s. There was a case for fiscal policy and unconventional monetary policy. But such policies are not new in Japan, and have had a long history. Simply saying “we can show this with an ISLM or whatever model because of a flat LM curve” etc etc is not properly informed analysis. It’s gimmick. None of this anyway gives the real reasons why macro policy has given such low multiplier effects in Japan. The analysis comes from the bottom up after you have put together the pieces of your primary and secondary documentation. This will require synthesis, but it should not draw on models for answers. Factual evidence will include crucial and verifiable information that cannot be quantified. For example you may have documentation which quotes government, financial or industrial figures saying “we did this because of this”.

        There is a strong case for opening up economics to other disciplines. There has long been a large Japanese history literature on these subjects. But there is little interaction between historians (including economic historians – particularly people strong on the history side) and neo-classical economists.

    • I meant to add that AS-AD supposes that we could aggregate demand and supply schedules for rival and substitute goods, which would be a neat trick of reflexive counterfactual speculation run amok, particularly for an actual economy where many goods are being sold simultaneously at many different prices and produced at marginal cost much less than any of those prices. But, again why let reality intrude when you have a faux nobel?

      • I hear people can’t remove themselves from say Apples walled garden e.g. every aspect of their lives.

  2. In one important sense Keynes and Friedman were saying the same thing. Keynes said recessions were caused by a fall in aggregate demand. Friedman thought recessions occur because of a contraction in money. They were both right. Money and aggregate demand amount to the same thing.

    • Yet Milton did everything under the sun to destroy demand with his share holder value meme et al enabling and increasing the financialization venturi vector approach. We just had Ken Henry here down under do his Greenspan mea culpa on that meme.

      Distribution and the VoM became a very small world.

  3. A brigthed economist once. He wrote some good books on international trade some 40 years ago. but
    he has put the brush on the shelf somewhere, on the east coast of the US i guess and is now living as a commentator in the magazines of rank nowadays. A sad story. Understand Keynes ?No way. Paul Samuelson did it better,at least. Unceratity? No way.

  4. Except the economy does not run on money (fiat) but on bank deposits. Yes, Federal spending creates bank deposits 1-for-1 with the new reserves but banks can also create bank deposits (“Bank loans create bank deposits”).

    So the question should be: Are bank deposits neutral?

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