The neutrality of money is a concept in economics that dates back to the 19th century. Over the years the meaning of the term 'neutral money' has meant several slightly different things, but it has come to refer to the money supply's effect on total economic output.
In other words, it concerns whether or not an active monetary policy will cause any real effect on the level of unemployment, interest rates, wages and so on. Analysis of this is then divided between static and dynamic models, which I will explain below.
As the name suggests, believers in the neutrality of money claim that only the price level will be affected by manipulations of the money supply, whilst real economic variables will be unaffected.
At the extreme end of the spectrum, the neoclassical economists believe that economic agents will react immediately to anticipated monetary policy actions such that the price level will fully offset monetary changes, and real economic variables will not be affected even temporarily. E.g., if the authorities decided to boost the money supply by 20% then prices would immediately rise by 20% with no effect on output or employment levels.
Most economists take a different view to this, and some believe that permanent long-term effects result from monetary policy changes. I will explain these perspectives below.
The 'classical dichotomy' is based on analysis of the static models that I referred to above. For classical economists it starts with an assumption that the economy is operating at its long-run equilibrium point, where unemployment is at its natural rate, and there is no spare capacity in the economy to permanently increase output.
The classical dichotomy is derived from the quantity theory of money which states that MV=PY. In words this means that the money supply in an economy multiplied by the number of times that it circulates through the economy, is equal to the price-level multiplied by the total quantity of goods and services produced.
This is actually an accounting identity, which simply means that total expenditure (MV) in the economy is equal to the value of total output produced (PY).
Money is regarded here as nothing more than a facilitator of trade, and increasing it will not cause any more goods or services to exist because it cannot affect productivity. All that it will cause is an increase in the price level.
Of course, reality is more complicated than this.
It is worth noting that even the classical dichotomy enthusiasts accept that the composition of output can change when the money supply is changed. For example, any extra money introduced into an economy will not be received by every citizen in the same relative proportions or at the same time. So some people will benefit from monetary policy shifts whilst others will lose out, but overall the classical economists predict no real change.
In contrast to the classical viewpoint, Keynesian economists start with an assumption that an active monetary policy can make real and permanent changes to output levels if it is enacted at times when the economy is under-performing i.e., when there is spare-capacity in the economy, a money supply boost can help the economy to expand.
Empirical evidence on the matter has shown fairly conclusively that the neutrality of money does not exist in the short-run, and that real economic variables are indeed influenced by monetary policy shifts.
However, in the long-term it appears that the classical economists are correct. Active monetary policies do not make any permanent changes to the economy, only prices are permanently affected, whilst output and employment levels will return to their natural rate. The process by which this occurs is explained on my page about the:
Whilst the static models are useful for highlighting general concepts, they are limited in their ability to paint a big enough picture of real-world changes caused by monetary policy shifts.
The dynamic models of the neutrality of money go further than highlighting general concepts, and attempt to look at the wider implications of money-supply changes on a constantly adapting economy.
Since the central assertion of the static NAIRU model is that a permanently higher inflation rate will be the only long-term result of an expansionary monetary policy, we need to take this analysis to the next step and investigate the long-term effects of higher inflation.
I have answered this question in some detail on my page about:
That page is instructive on the ravages of inflation, but if you don't have time to read it then it suffices to say that the effects of higher inflation are highly undesirable and unfair. The worst impact of high inflation is leveled on the poor, because there is a significant re-distributive impact of rising prices that takes money from the poor in favor of the rich.
Clearly this is a serious issue, and it demonstrates a serious limitation of the static models' sole focus on aggregate measures whilst failing to account for the changing composition of national income that results from monetary expansion.
We can deduce from the preceding sections that it is only in the very loose sense proposed by the static models that the neutrality of money can be said to exist. Even then, empirical evidence has convincingly shown that there is no neutrality of money in the short-run, and that the neo-classical economists have failed to demonstrate any adherence to the rational expectations theory to which they align.
Money is not neutral in its effects on real people, not in the short-run, and not even in the long-run once we go beyond static analysis and look at the more comprehensive dynamic models.
Nevertheless, the question that remains relates to optimal policy choices.
If an active monetary policy boost/contraction can help to smooth out the boom-bust business cycle then the benefits of using it should outweigh the costs. Unfortunately, the evidence of the monetary authorities' success in this area is overwhelmingly absent. The current state of the national debt and the mounting budget deficit is testimony to that.
The weight of evidence suggests that active monetary policy has actually had a destabilizing effect on economic output, and when the re-distributive effects of the resulting inflation due to the non-neutrality of money are added to this destabilization, the costs borne by our society, particularly the poorest members of it, have been severe to say the least.