Which of the following best describes a fundamental assumption when monetary policy is used to influence the economy?
B is correct. If money were neutral in the short run, monetary policy would not be effective in influencing the economy.
help me understanding this word play
Greetings friend!
The word play here relates to the neutrality of money theory. This theory basically says that money supply has only a “nominal” effect but no “real” effect on the economy. Here is a Wikipedia article that explains it probably better than I can: Neutrality of money - Wikipedia
So what is monetary policy then? Well, in the simplest terms, it’s typically one of 2 things or a combination of the 2. Either a government is printing more money than usual (to increase the money supply), or its central bank is using “short-term” interest rate adjustments to either increase or decrease the amount of money freely circulating around. Or a combination of both.
Think of this question in terms of central bank activities. When a central bank increases short-term interest rates, more money becomes parked in the now higher-interest bearing securities. The opposite happens when it reduces short-term interest rates, more money goes back into general circulation in pursuit of higher returns etc.
Answer B (Money is not neutral in the short run) basically recites this in a nutshell. It is saying monetary policy is based on the idea that money is not neutral in the short term. The supply of money (due to a central bank’s adjustment of short-term interest rates) has a real effect on the economy at that particular given point in time. This is why everyone watches any interest rate announcements so intently, for example.
Monetary policy is based on the notion that a central bank’s adjustment of short term interest rates, in order to reduce or increase monetary supply, has a real effect on the economy and the business cycle we’re in. Because if it didn’t have any real effect on the economy then the whole exercise by central banks would be like rearranging chairs on the titanic - pointless.
But what about long-run money neutrality? Well, traditional economic theory says changes in the money supply or short-term interest rates can influence the business cycle (short run), but NOT the potential long-run output. So you often hear the phrase “money is neutral over the long run.” In the short-run however (we are talking about the current and near business cycles particularly), monetary policy does have an effect so money is “not” neutral in the short run.
Cheers - good luck on your exam - you got this 