Home > New vs. Old Paradigm > Money is NOT neutral in the long run

Money is NOT neutral in the long run

from Lars Syll 

Paul Krugman has often tried to explain why 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.

Well, this “fairly Keynesian” guy is not impressed. And I doubt that Keynes himself 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 neoclassical economists — is that there is no automatic tendency for economies to move toward full employment levels in monetary economies.

Money doesn’t matter in neoclassical macroeconomic models. That’s true. But in the real world in which we happen to live in, 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 situ-ation, 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. SJB
    April 23, 2015 at 11:14 pm

    The concept of price flexibility in the labor market ought to go as well. People aren’t like fresh produce, but economists act like they are. It costs money to have a job. You have to dress accordingly, pay for transportation and incur various other costs associated with working. At some point it is simply not worth it to work in a traditional job, even if there isn’t a social safety net. People will resort to charity, begging, stealing or engaging in some other criminal behavior. Some people commit suicide. I have known people who have done that.

    In the real world labor markets are nothing like what is portrayed in economics. Some employers are abusive, and are able to keep doing it because they are the only game in town. They pay what they can get away with, regardless of the value of the employees work. Remember Steve Jobs and the other Silicon Valley execs who colluded to keep workers pay low? Some employers actually care about their workers, and want to do what they can for them because they become like family. Both of these kinds of situations are not uncommon in small businesses though in larger companies institutional factors may limit individual managers’ ability to affect pay and working conditions.

    Also, when wages are low people are demoralized, which can lead to a whole host of social problems, none of which get accounted for in economics. “Full employment” doesn’t mean life is good for the employees.

    Behavioral economists must surely know that a cut in pay is going to have a bigger negative impact on employees than an equal increase in pay would have in a positive direction. This in itself should indicate that wage flexibility is a tricky thing.

    I’m not a labor economist, so I don’t know to what extent flexibility is taken seriously in the field. But with Krugman saying this, clearly some economists still believe it. Power positions are ignored because they are hard to model.

    And the elephant in the room that economists always ignore is this: As technology advances, as markets become more integrated, and probably other things that I can’t think of now, there are going to be situations in which there is no demand for available labor, no matter how much flexibility there is in the market.

    Look at Detroit. It is an extreme example but it is a telling one. There are thousands of little Detroits across the US, in farm communities where increased farm size has squeezed out small farm suppliers; in bigger communities where the local textile mill, or steel mill, or manufacturer closed; and in cities which were hollowed out by suburb growth and various other factors. Even if there were jobs in other places, some people can’t move to where the jobs are. But the simple fact is there aren’t enough jobs to go around.

    Economists need to stop arguing about theoretical assumptions and start looking at what is really happening. People are living and dying, struggling and suffering, doing whatever they can to cope with hard realities that we choose to ignore. It seems to me we ought to get out of the ivory towers, and start getting to know people who are not like us, but who live with the consequences of the theories we develop, as well as the facts we ignore.

    I think that Keynes would agree. He was the first to talk about defunct economists.

  2. ihtis69
    April 24, 2015 at 5:53 pm

    Reblogged this on ihtis69.

  3. Larry Motuz
    April 24, 2015 at 8:45 pm

    The Victorian notion that there was a balance in nature entered economics through the classics and was preserved in the various ideas of market and general equilibrium of the latter 19th and early 20th centuries.

    This notion of a ‘natural’ balancing has served to keep economics pseudo-scientific. No serious scientific construction of economics can incorporate this mythology.

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