Classical dichotomy
Encyclopedia
In macroeconomics
, the classical dichotomy refers to an idea attributed to classical
and pre-Keynesian economics that real and nominal variables can be analyzed separately. To be precise, an economy exhibits the classical dichotomy if real variables such as output and real interest rate
s can be completely analyzed without considering what is happening to their nominal counterparts, the money value of output and the interest rate. In particular, this means that real GDP
and other real variables can be determined without knowing the level of the nominal money supply
or the rate of inflation
. An economy exhibits the classical dichotomy if money is neutral
, affecting only the price level, not real variables.
The classical dichotomy was integral to the thinking of some pre-Keynesian economists ("money as a veil
") as a long-run proposition and is found today in new classical theories of macroeconomics. Keynesians
and monetarists
reject the classical dichotomy, because they argue that prices are sticky
. That is, they think prices fail to adjust in the short run
, so that an increase in the money supply raises aggregate demand
and thus alters real macroeconomic variables. Post-Keynesians reject the classic dichotomy as well, for different reasons, emphasizing the role of banks in creating credit money
, as in monetary circuit theory
.
In simple words it is the idea that real and nominal variables can analyse separately. Here changes in money variables do not affect real variables like employment,output and interest rate.so money is neutral, ie: the economy lies in dichotomy and money supply only affects price level hence it is nominal variable;
(1954) challenged the classical dichotomy as being inconsistent, with the introduction of the 'real balance effect' of changes in the nominal money supply
. The early classical writers postulated that money is inherently equivalent in value to that quantity of real goods which it can purchase. Therefore, in Walras
ian terms, a monetary expansion would raise prices by an equivalent amount, with no real effects on employment
or output. Patinkin postulated that this inflation could not come about without a corresponding disturbance in the goods market. As the money supply is increased, the real stock of money balances exceeds the 'ideal' level, and thus expenditure on goods is increased to re-establish the optimum balance. This raises the price level in the goods market, until the excess demand is satisfied, at the new equilibrium. He thus argued that the classical dichotomy was inconsistent, in that it did not explicitly allow for this adjustment in the goods market. Later writers (Archibald & Lipsey, 1958) argued that the dichotomy was perfectly consistent, as it did not attempt to deal with the 'dynamic' adjustment process, it merely stated the 'static' initial and final equilibria.
analysis can be performed using a jacobian matrix in block triangular form. That is, suppose we write
where
represents some exogenous shocks (changes in productivity, aggregate demand, money supply, etc., ordered so that all real shocks come first), and 
represents the change in the endogenous variables (output, employment, prices, etc., again listing real variables first). Then the matrix
J can be partitioned into submatrices as follows:
In other words, when the classical dichotomy holds, it is possible to calculate how all the real variables change by inverting the submatrix
only, thus excluding all nominal variables like money supply and prices from the analysis.
Macroeconomics
Macroeconomics is a branch of economics dealing with the performance, structure, behavior, and decision-making of the whole economy. This includes a national, regional, or global economy...
, the classical dichotomy refers to an idea attributed to classical
Classical economics
Classical economics is widely regarded as the first modern school of economic thought. Its major developers include Adam Smith, Jean-Baptiste Say, David Ricardo, Thomas Malthus and John Stuart Mill....
and pre-Keynesian economics that real and nominal variables can be analyzed separately. To be precise, an economy exhibits the classical dichotomy if real variables such as output and real interest rate
Real interest rate
The "real interest rate" is the rate of interest an investor expects to receive after allowing for inflation. It can be described more formally by the Fisher equation, which states that the real interest rate is approximately the nominal interest rate minus the inflation rate...
s can be completely analyzed without considering what is happening to their nominal counterparts, the money value of output and the interest rate. In particular, this means that real GDP
Real GDP
Real Gross Domestic Product is a macroeconomic measure of the value of output economy adjusted for price changes . The adjustment transforms the money-value measure, called nominal GDP, into an index for quantity of total output...
and other real variables can be determined without knowing the level of the nominal money supply
Money supply
In economics, the money supply or money stock, is the total amount of money available in an economy at a specific time. There are several ways to define "money," but standard measures usually include currency in circulation and demand deposits .Money supply data are recorded and published, usually...
or the rate of inflation
Inflation
In economics, inflation is a rise in the general level of prices of goods and services in an economy over a period of time.When the general price level rises, each unit of currency buys fewer goods and services. Consequently, inflation also reflects an erosion in the purchasing power of money – a...
. An economy exhibits the classical dichotomy if money is neutral
Neutrality of money
Neutrality of money is the idea that a change in the stock of money affects only nominal variables in the economy such as prices, wages and exchange rates, with no effect on real variables, like employment, real GDP, and real consumption....
, affecting only the price level, not real variables.
The classical dichotomy was integral to the thinking of some pre-Keynesian economists ("money as a veil
Veil of money
Veil of money describes a problem in economics, which centers on the question of whether money is a commodity like other commodities, such as oil or gold or food - or whether it has special properties....
") as a long-run proposition and is found today in new classical theories of macroeconomics. Keynesians
Keynesian economics
Keynesian economics is a school of macroeconomic thought based on the ideas of 20th-century English economist John Maynard Keynes.Keynesian economics argues that private sector decisions sometimes lead to inefficient macroeconomic outcomes and, therefore, advocates active policy responses by the...
and monetarists
Monetarism
Monetarism is a tendency in economic thought that emphasizes the role of governments in controlling the amount of money in circulation. It is the view within monetary economics that variation in the money supply has major influences on national output in the short run and the price level over...
reject the classical dichotomy, because they argue that prices are sticky
Sticky (economics)
Sticky, in the social sciences and particularly economics, describes a situation in which a variable is resistant to change. Sticky prices are an important part of macroeconomic theory since they may be used to explain why markets might not reach equilibrium right away. Nominal wages are often said...
. That is, they think prices fail to adjust in the short run
Long run and short run
In macroeconomics, the long run is the conceptual time period in which there are no fixed factors of production as to changing the output level by changing the capital stock or by entering or leaving an industry. The long run contrasts with the short run, in which some factors are variable and...
, so that an increase in the money supply raises aggregate demand
Aggregate demand
In macroeconomics, aggregate demand is the total demand for final goods and services in the economy at a given time and price level. It is the amount of goods and services in the economy that will be purchased at all possible price levels. This is the demand for the gross domestic product of a...
and thus alters real macroeconomic variables. Post-Keynesians reject the classic dichotomy as well, for different reasons, emphasizing the role of banks in creating credit money
Credit money
Credit money is any claim against a physical or legal person that can be used for the purchase of goods and services. Examples of credit money include personal IOUs, and in general any financial instrument or bank money market account certificate, which is not immediately repayable in specie, on...
, as in monetary circuit theory
Monetary circuit theory
Monetary circuit theory is a heterodox theory of monetary economics, particularly money creation, often associated with the post-Keynesian school....
.
In simple words it is the idea that real and nominal variables can analyse separately. Here changes in money variables do not affect real variables like employment,output and interest rate.so money is neutral, ie: the economy lies in dichotomy and money supply only affects price level hence it is nominal variable;
Controversy
Don PatinkinDon Patinkin
Don Patinkin was an Israeli/American monetary economist, and the president of Hebrew University in Jerusalem.- Biography :...
(1954) challenged the classical dichotomy as being inconsistent, with the introduction of the 'real balance effect' of changes in the nominal money supply
Money supply
In economics, the money supply or money stock, is the total amount of money available in an economy at a specific time. There are several ways to define "money," but standard measures usually include currency in circulation and demand deposits .Money supply data are recorded and published, usually...
. The early classical writers postulated that money is inherently equivalent in value to that quantity of real goods which it can purchase. Therefore, in Walras
Walras
Walras is surname of:* Auguste Walras , French school administrator and economist* Léon Walras * Walras' law...
ian terms, a monetary expansion would raise prices by an equivalent amount, with no real effects on employment
Employment
Employment is a contract between two parties, one being the employer and the other being the employee. An employee may be defined as:- Employee :...
or output. Patinkin postulated that this inflation could not come about without a corresponding disturbance in the goods market. As the money supply is increased, the real stock of money balances exceeds the 'ideal' level, and thus expenditure on goods is increased to re-establish the optimum balance. This raises the price level in the goods market, until the excess demand is satisfied, at the new equilibrium. He thus argued that the classical dichotomy was inconsistent, in that it did not explicitly allow for this adjustment in the goods market. Later writers (Archibald & Lipsey, 1958) argued that the dichotomy was perfectly consistent, as it did not attempt to deal with the 'dynamic' adjustment process, it merely stated the 'static' initial and final equilibria.
Mathematical representation
If an economy exhibits the classical dichotomy, then comparative staticsComparative statics
In economics, comparative statics is the comparison of two different economic outcomes, before and after a change in some underlying exogenous parameter....
analysis can be performed using a jacobian matrix in block triangular form. That is, suppose we write
where
represents some exogenous shocks (changes in productivity, aggregate demand, money supply, etc., ordered so that all real shocks come first), and represents the change in the endogenous variables (output, employment, prices, etc., again listing real variables first). Then the matrixMatrix (mathematics)
In mathematics, a matrix is a rectangular array of numbers, symbols, or expressions. The individual items in a matrix are called its elements or entries. An example of a matrix with six elements isMatrices of the same size can be added or subtracted element by element...
J can be partitioned into submatrices as follows:
In other words, when the classical dichotomy holds, it is possible to calculate how all the real variables change by inverting the submatrix
only, thus excluding all nominal variables like money supply and prices from the analysis.