Superneutrality, Nominal Interest, Real Interest and Wealth Effects

This note is originally posted on Thursday, 7 February 2013 at 23:28

The Neutrality of money is a proposition that any change in the money supply will ultimately only affect nominal variables, with no change to real variables.

The expected inflation rate acts as the differential between real and nominal interest, formalized in Fisher's Equation:

i = r + E[inf] 

When the economy does not hold any inflationary expectations ( E[inf] is zero), real and nominal interest will equalize. 

Suppose the economy does not have any inflationary expectations- the absolute price level clears the demand and supply at the aggregate level. Neutrality is easily observed by the adjustments in the money market- an initial shift in money supply induces change in the price level, which will eventually restore real balances. The economy will be restored to its original level of interest rates and output- although the absolute price has risen.  

Neutrality, however, only deals with the absolute price level. In the long run, the focus is turned to the effects of money growth on growth rates of real and nominal variables. Since long run growth is a continuous process, the relative changes in money supply (money growth rate) and price level (inflation rate) will be key determinants in this analysis. 

Money Demand (Md/P) is a function of real output and nominal interest rate.

Md/P = L(Y, i) 

By the Fisher's Equation. 

Md/P = L(Y, r + E[inf] ) 

Suppose the IS-LM diagram is plotted as i (nominal interest) against Y (output).

Any changes to the inflation rate will be reflected by an upward shift of the LM curve. The acceleration of inflation will ultimately feed into the agents' expectations of inflation.

If real interest remains unchanged and expectations are rationally formed & fully anticipated, the nominal interest will follow the exact change in inflation rate at all equilibirum points. This will be reflected in the upwards shift of the IS curve. The changes in nominal interest responding to a change in expected inflation is known as the Fisher Effect.

The effects of the shifts of the IS and LM curves on output tend to cancel out one another- the initial output will be restored.

In this case, money is superneutral. The change in inflation rate has no effect on real interest rates and consequently the evolution of output growth. 

Memo: Just realized that I have a misconception about Superneutrality. Although it is true that under Superneutrality, any change in money growth will only affect inflation rate without any effect on real growth, the primary focus should be on whether real interest changes if inflation accelerates because it is via effects on investments that indirect transmission of monetary effects on the real sector takes place.