Classical dichotomy: Difference between revisions

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{{Short description|Idea that real and nominal variables can be analysed separately}}

The [[classical dichotomy]] is the division between real money, which is measured in physical terms and is usually supposed to be a better indicator of money value due to its stability, and nominal money, which is measured in terms of a currency and hence is susceptible to inflation. It was a term coined by the early 20th century classical writers. According to [[Milton Friedman]], who is commonly referred to as the father of monetary economics, different forces influence real and nominal variables (money value here) and changes in the money supply affect nominal variables but not real variables. This irrelevance of monetary changes for real variables is called [[monetary neutrality]].

In [[macroeconomics]], the '''classical dichotomy''' is the idea, attributed to [[classical economics|classical]] and pre-[[Keynesian]] economics, that [[Real versus nominal value (economics)|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 [[neutrality of money|neutral]], affecting only the price level, not real variables.{{citation needed|date=August 2012}} As such, if the classical dichotomy holds, money only affects [[Real versus nominal value (economics)|absolute rather than the relative prices]] between goods.

The classical dichotomy was integral to the thinking of some pre-Keynesian economists ("[[Veil of money|money as a veil]]") as a long-run proposition and is found today in [[new classical economics|new classical]] theories of macroeconomics. In new classical macroeconomics there is a short-run [[Phillips curve]] which can shift vertically according to the [[rational expectations]] being reviewed continuously. In the strict sense, money is not neutral in the short-run, that is, classical dichotomy does not hold, since agents tend to respond to changes in prices and in the quantity of money through changing their supply decisions. However, money should be neutral in the long run, and the classical dichotomy should be restored in the long-run, since there was no relationship between prices and real macroeconomic performance at the data level. This view has serious economic policy consequences. In the long-run, owing to the dichotomy, money is not assumed to be an effective instrument in controlling macroeconomic performance, while in the short-run there is a trade-off between prices and output (or unemployment), but, owing to rational expectations, government cannot exploit it in order to build a systematic countercyclical economic policy.<ref>{{cite book |last=Galbács |first=Peter |title=The Theory of New Classical Macroeconomics. A Positive Critique |___location=Heidelberg/New York/Dordrecht/London |publisher=Springer |year=2015 |isbn= 978-3-319-17578-2 |doi=10.1007/978-3-319-17578-2 |series=Contributions to Economics }}</ref>

[[Patinkin]] (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 clasical writers postulated that money is inherently equivalent in value to that quantity of real goods which it can purchase. Therefore, in [[Walrasian]] terms, a monetary expansion would raise prices by an equivalent amount, with no real effects (employment, growth). Patinkin postulated that this inflation could not come about without a corresponding disturbance in the goods market, through the 'real balance effect'. 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 - the price adjustment was assumed to be immediate - the [['invisible hand']].

[[Keynesian economics|Keynesians]] and [[Monetarism|monetarists]] reject the classical dichotomy, because they argue that prices are [[sticky (economics)|sticky]]. That is, they think prices fail to adjust in the [[Long run and short run|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 [[money creation|creating money]], as in [[monetary circuit theory]].

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.

==References==

{{Reflist}}

==Further reading==

* Roy Green (1987). "Classical theory of money," ''[[The New Palgrave: A Dictionary of Economics]]'', v. 1, p.&nbsp;449.

* [[Don Patinkin]], (1987). "Neutrality of money," ''The New Palgrave: A Dictionary of Economics'', v. 3, pp.&nbsp;639–644.

* [[Huw Dixon]], [http://huwdixon.org/SurfingEconomics/chapter3.pdf Of Coconuts, decomposition and a Jackass: the genealogy of the Natural Rate], [http://huwdixon.org/SurfingEconomics/index.html Surfing Economics], Chapter 3.

{{United States – Commonwealth of Nations recessions}}

[[Category:Monetary economics]]

[[Category:Classical economics]]

[[Category:Macroeconomic theories]]

[[Category:Dichotomies]]