On the non-neutrality of money

24 Mar, 2020 at 10:12 | Posted in Economics | 4 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 with 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. That’s true. 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. Absolutely agree – neutrality of money is a concept that will lead economists to be wrong about pretty much everything at the macro level. But what I really love is that you posted this at the height of the coronavirus – so refreshing reading down my twitter feed and finding this!

  2. Krugman is a neoclassist mainly.That put in little “Keynes” in here and there , But he is a Princeton, ordinary guy, he stay, no other stance. His ” Trade theory” don´t impress me at all, development of Heckscher- Ohlin model.But he wright i NY Times,a week- Good job Paul.Be proud.

  3. I think part of the problem with the concept of money neutrality in the long run lies in a confused view of the concept of the long run. The Marshallian long run is the period of time when all inputs can be varied. The mainstream macro long run is a logical long run of what would happen if everything were held constant and prices and wages were ultimately flexible. It’s probably true that if you allowed 20% unemployment long enough, got rid of all labor unions, endured bankruptcies and survived the riots in the streets, eventually wages and prices probably would fall enough to get the economy moving again. I think that Marx hints at this idea in some ways. But Krugman’s long run is not a historical period of time-it’s a logical point of full employment of resources, or something close to it anyway. As a thought experiment, I think it’s probably true that if you really were at full employment and Central Banks undertook something like QE at that point, that you would generate inflationary pressures. But I don’t think that is really what is meant by “money neutrality”. I think some analysis of what the arguments are actually intended to mean would clear up a lot of confusion on the part of the mainstream and sharpen heterodox critiques. I suspect that the influence of natural language philosophy on Keynes had some impact on his dissection of the Classical model.

  4. I think the whole of the problem with the concept of money neutrality in the long run lies in a confused view of the concept of money. Krugman’s faith in the long-run neutrality of money seems to be founded on Hume’s observation that the numeric magnitude of the unit of account is arbitrary.
    Hume’s notion of what determined or maintained the value of the unit of account seems to have been based on a primitive quantity theory of money: a money is identical with coins, and so basically a matter of tokens circulating in commerce. Double the number of circulating tokens relative to the physical volume of commerce facilitated by the circulation of tokens and the value of the unit of account will fall by half. I doubt Krugman would want to defend that view, but it does seem to be the view that he holds.
    For the quantity theorist, money is not neutral in short-run, as the economy is always adjusting to balance supply with effective demand, meaning money-financed supply with money-financed demand, and it remains an open question whether, in particular circumstances, it is better to let transaction prices adjust thru processes of market price formation or to intervene to adjust the flow of money funds in order to reduce the high costs of adjusting the unit of account indirectly thru prolonged adjustment via market price formation. Thus,the brave talk of “flexible” wages and prices which are imagined to be less costly to adjust by market processes.
    Back here on planet earth, where most prices are not formed in recognizable market processes and money is credit and not tokens in any case, it is hard to take someone as ignorant as Krugman seriously. Which, I suppose, is why some mistake him for that other N.Y. Times idiot-pundit, Tom Friedman.

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