Examining the concept of money neutrality in two advanced economies

Abstract

The neutrality of money is an economic theory that states that changes in the money supply only affect nominal variables and not real variables in the long run. The term «neutrality of money» was first introduced by acclaimed economist and Nobel Prize winner Friedrich Hayek and was a result of conversation and debate that dates back to the 18th century. Since then it has become a staple idea for classical economists and it has influenced monetary policies all around the world. The purpose of this paper is to examine the basic idea of money neutrality in the long run and the short run in two major economies (USA and Canada). In order to do so we have used the Johansen co-integration test, Error correction models, VAR models and four time series (Real Gross Domestic Product, M1 money supply, M2 money supply and the Consumer’s Price index)for each of these two economies. Our results confirm the neutrality proposition in the long run but not in the short run.