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The Intuition behind Wallace Neutrality
  • Richard H. Serlin, University of Arizona

Wallace neutrality is a term that, as far as I know, was coined by University of Michigan economist Miles Kimball. It refers to the seminal model of Neil Wallace in "A Modigliani-Miller Theorem for Open-Market Operations", American Economic Review, June 1981. In Wallace's model, open market operations have no effect on any asset prices, including money (no effect on inflation). This is a shocking result, and it cries out for how and why. Intuitively, how and why can this possibly happen? However, like so many modern models, it's extremely difficult to see the intuition behind the wall of math, and I have not seen it anywhere after a great deal of searching. Moreover, misunderstanding of Wallace is rife, even among top tier economists. The paper, for example, is often used as "proof" that quantitative easing cannot be effective. It is therefore especially influential today. However, I believe I have decoded the math, and found the intuitions for why Wallace Neutrality – open market operations have no effect on any asset prices – exists in the model, and why it does not exist in the real world, which has been shown empirically. Note: This was written as a long blog post. So please be forewarned that it includes informal language, economic and political opinions, and humor (or attempts thereof).

  • Irrelevance proposition ; Fiat money ; Open market operations ; Modigliani ; Miller
Publication Date
July, 2015
Citation Information
Richard H. Serlin. "The Intuition behind Wallace Neutrality" (2015)
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