Introduction

Why can changes in monetary policy cause fluctuations in employment and production? This has been one of the most important and most intensely debated questions in economics ever since David Hume’s (1752) contributions. The issue of monetary non-neutrality is important because the misconduct of monetary policy may create enormous damage to the real economy and thereby affect the economic lives of millions of people. For example, abrupt and massive reductions in the quantity of money are claimed to have been responsible for severe depressions like the Great Depression in the 1930s or the 1982 recession in the United States. Thus, investigating the causes of monetary non-neutrality is important because it may help avoid misconduct in monetary policy. Despite the immense amount of theoretical and empirical research that has been produced in the last two centuries, the issue remains intensely debated for two reasons. First, it is difficult to identify and accurately measure the variables of interest. For example, the quantity of money is a concept which is not easily defined, and the price level is difficult to measure. In addition, presumed causalities are hard to establish by analyzing field data since many (unobservable) variables may change simultaneously. The second reason why the question of monetary neutrality remains controversial is of methodological nature. Economists have established a firm tradition to approach the issue of monetary (non-) neutrality by assuming that all economic agents are fully rational and form rational expectations. This assumption has kept its strong position up to the day. Hence, money illusion has been dismissed as an explanation of monetary non-neutrality on a priori grounds.