Question

What is monetary neutrality? Using IS-LM framework, argue that why is not neutral according to Keynasian theory.

Answer 1

Money neutrality means that the changes in money supply affects only the nominal variables and not the real variables. Now, following the quantity demand of money equation MV = PY, V and Y do not change with change in Money supply, it is only P or price level which changes to adjust the changes in money supply. This is not so in IS-LM framework because according to Keynesian theory, a change in the money supply leads to a change in the demand for money which shifts the LM curve in the money market. Now, the interest rate and output achieve a new short run equilibrium in the money market. In order to bring the economy at the equilibrium the goods market also adjusts thereby leading to a shift in the IS curve. These movements in the IS and LM curve leads to a new interest rate and GDP or output equilibrium. Hence, in case of Keynesian Theory, changes in money supply affects the real variables.