Friday, October 12, 2012
The Neutrality of Money and the Supply and Demand Diagram
I just had an epiphany which I’d like to share with you: the neutrality of money is baked into the standard supply and demand diagram that enters the first-year economics brain and never leaves.
Recall the following point: putting together all the factors on which sellers base their preferences, and all the factors on which buyers base their preferences, an equilibrium price is determined. If the actual price is above this equilibrium, excess supply will generate downward pressure until equilibrium is reached. If the actual price is below, excess demand does the job. It doesn’t matter what the price happens to be at the moment; it will gravitate toward the same equilibrium which has been determined by factors other than this price.
That embodies the neutrality of money. By “money” I mean not simply the price level, but also the full range of effects generated by the financial system. Financial activity can alter the prices of individual goods: commodities markets influence the price of minerals and agricultural products, markets in mortgages and their derivatives influence the price of homes, and so on. The financial sector, in a money-neutral world, is determined by but ultimately does not determine the “real” world of production possibilities and preferences. That is why finance can be an add-on to economic models that can be specified with or without it. In a money-non-neutral world, everything really does determine everything else, with no distinction between “monetary” and “real”.
For some people the logic of the supply and demand diagram is a reason for accepting this neutrality. For me it’s a reason to take a closer look at the model and question what subtle, long-lasting mental poisons we are releasing into the environment each time we (economics professors) teach it.
The answer, we know, is locked in those infamous ceteris paribus conditions. This becomes transparent at the level of general equilibrium, where Sonnenschein-Debreu-Mantel tells us that changes in actual prices have the power to alter their equilibrium levels. If you really, truly understand this, you see money and finance differently. The problem is how to convey this same insight at the level of the simpler, more visible models on which introductory economics is based. It’s hard to repair the damage caused by years of learning “the economic way of thinking”.