This paper evaluates the effect of a change in the quantity of money on relative prices in the U.S. economy based on quarterly time-series for the period of 1959 to 2013. We also estimate the implication of a change in relative prices on the rate of inflation and macroeconomic variables. The empirical results indicate that the change of money supply not only affects relative prices but also affects the inflation rate and real variables, such as investment, natural rate of unemployment and potential GDP, through the change in relative prices. The relevant finding of our study is that money is not neutral in a non-traditional sense because a change in the money supply disturbs relative prices and, consequently, the allocation of resources in the economy. This finding has serious implications that must be considered in the transmission mechanisms of monetary policy.
Economists in general agree with the idea that the observed variations in the nominal price are related to changes in the quantity of money. The history of hyperinflation corroborates this view [1,2]. In this context, [3] highlight some interesting facts in a cross-section study regarding to the ability of changes in money growth to affect inflation or output change. This study applies different concepts of money supply. The correlations that they compute reveal some interesting points. In the long run (a) there is a high correlation between the rate of money supply and the rate of inflation; (b) there is no correlation between the growth rate of money and real output; and (c) there is no correlation between inflation and real output. In a certain way, these findings are in accordance with what [4] predicted: changes in the money supply cannot disturb real variables in the long run, but only in the short run. This means money is neutral in the long run.
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However, there are not enough studies regarding the specific role played by the change in the quantity of money on the structure of relative prices. It can be the case that even when money is neutral in the traditional approach of the quantity theory of money (QTM), changes in the money supply can modify relative prices in the economy.
In other words, despite the macroeconomic effect considering the general price level, one cannot ignore the possibility that there exist microeconomic implications derived from a change in the money supply even in long run. In this sense, the traditional approach of QTM failed to establish the basis for microeconomic studies of monetary economy. Although some economists [4,5,6,7] have already developed works in monetary economics with microeconomic fundamentals, there are still some relevant aspects that an aggregate analysis cannot contemplate.
In the context of procyclical leverage and banking catastrophes, [21] have studied the mechanisms by which a financial crisis spreads. The authors highlight the asymmetric reaction of balance sheet to positive and negative shocks, the possibility of discontinuous asset price declines, and the path dependence of portfolio adjustments in response to changing beliefs.
Later [24,25] use a general equilibrium framework with a rational expectations hypothesis to model the natural rate of unemployment and to demonstrate the neutrality of money. In this paper, we assess whether monetary policy through changes in relative prices affects not only the natural rate of unemployment but also the growth rate of potential output. If this is the case, we can reject the notion of the neutrality of money in a non-traditional sense because a change in the money supply disturbs relative prices and, consequently, the allocation of resources in the economy.
Using quarterly data from 1959:2 to 2013:02 we perform an econometric analysis to evaluate the follow issues: i) the direct effect of the change in the money supply on the change in relative prices; ii) the indirect impact of the change of money supply on the inflation rate; iii) the indirect impact of the change of money supply on the variation of real investment; iv) the indirect impact of the change of money supply on the natural rate of unemployment; and v) the indirect impact of the change of money supply on the change in the real potential GDP.
Our database allows plenty of distinct relative prices to be evaluated. We opt for the ratio between the producer price index and the consumer price index to represent the relative price variable. As we show in section 3, one can estimate how much a change in the money supply can distort relative prices.
One of the postulates of the quantity theory of money is the dichotomy between relative prices and absolute prices, which is guaranteed if changes in relative prices are explained by changes in real variables such as GDP and employment, while absolute price movements are explained by changes in the money supply. This dichotomy means that given the supply of money, the velocity of money and the level of trade in goods, changes induced by a real shock in the relative prices produce compensatory changes in other relative prices, so that the absolute level of prices remain unchanged [28]. However, in our view, nothing guarantees that such changes are offset so that the general price level remains unchanged.
The econometric results display evidence that a change in the money supply affects the relative prices. This result does not corroborate the assumption that changes in relative prices only occur due to changes in real variables such as unemployment rate, technological shocks, etc. Moreover, a change in relative prices, resulting from changes in the quantity of money, must be considered when analyzing monetary policy transmission mechanisms because they indirectly affect real economic variables such as investment, natural rate of unemployment and potential output. In sum, we find empirical evidence that money is not neutral in a non-traditional sense because a change in the money supply disturbs relative prices and, consequently, the allocation of resources in the economy.
The idea behind the neutrality of money is strongly related with the quantity theory of money that was made popular by [29] based on the famous identity, MV = PY. This identity states that the price level (P) varies directly with the quantity of money (M) considering that the velocity (V) of circulation of money and the volume of transactions (Y) of final goods and services do not change. In this context, [24] published one of the most famous articles on neutrality of money that relates monetary shocks to relative and absolute prices. It shows that monetary shocks have real effects in the short term because agents have information asymmetry and they cannot distinguish whether the change in prices is relative or absolute. The author concludes that in the long run, however, money is neutral.
The majority of theories that try to model money neutrality are in certain way connected with this theory. Of course, as proposed by many economists, a given change in the money supply has an effect on real variables during a transition period, that is, until the price level adjusts completely in a new steady-state equilibrium. Unfortunately, this type of analysis does not take into consideration the microeconomic aspects involved in this process. First, it considers the monetary issues in a secluded bay where the marginal utility, value and prices are not connected. The quantity theory of money developed its concepts through economic aggregates such as general price level, velocity of money and domestic output.
Following this theory, a change in the quantity of money can change relative prices and, consequently, modify price signals. Here the rates of return of the various combinations of capital are altered. This new rearrangement of relative prices of goods and services will differ from those determined by the fundamentals. The new price arrangement points to an increase in the profits of certain firms at the expense of others. What type of monetary expansion can recurrently produce changes in relative prices? In accordance with [30,31,32], there is a classical case in which growth in the money supply distorts relative prices and, consequently, resource allocation. This happens when growth in the money supply is related to the expansion of bank credit not derived from the market but from the injection of new money by the monetary authority. This increase in the money supply increases the availability of loanable funds leading to a fall in interest rates and, in turn, the promotion of investment. In this case, the increase in lending is not matched by growth in the flow of production factors available that can be used to fit this increased demand for new investments. For [30,31,32] this is the main cause of the business cycle.
Thus, changes in prices due to inflation only start with some goods and services. This process then spreads slowly from one group to another. It takes time until the additional amount of money has permeated the entire economy and has exhausted all possibilities of price change. Even at the end of the process, however, various goods and services are not affected to the same degree. The process of gradual currency depreciation resulting from increased money supply changes the income and wealth of different social groups. The process of depreciation will occur while the additional amount of money does not exhaust all its possibilities to influence prices. The process of accelerating inflation severely and unequally penalizes different social groups. The end result of a long inflationary process is a new economic order resulting in dispersion of wealth and income.
The parameter α in the autoregressive components tries to capture the inertia in the dynamics of the dependent variable. The basic hypothesis behind this equation is that changes in relative prices result from changes in the quantity of money and from the real sector of the economy that is represented in Eq (1) by the change of real output. The effect on relative prices derived from other variables, for instance the interest rate, occurs through a change in the money supply as a consequence of a change in these variables. We use M2 to represent the money supply. 2ff7e9595c
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