Classical dichotomy

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 rates 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;

Controversy

Don 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 classical 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 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.

Mathematical representation

If an economy exhibits the classical dichotomy, then comparative statics analysis can be performed using a jacobian matrix in block triangular form. That is, suppose we write

$\mathbf{J}dy = dx$

where dx represents some exogenous shocks (changes in productivity, aggregate demand, money supply, etc., ordered so that all real shocks come first), and dy 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:

$\mathbf{J}= \begin{bmatrix} A & 0 \\ B & C \\ \end{bmatrix}$

In other words, when the classical dichotomy holds, it is possible to calculate how all the real variables change by inverting the submatrix A only, thus excluding all nominal variables like money supply and prices from the analysis.

References

• Roy Green (1987). "Classical theory of money," The New Palgrave: A Dictionary of Economics, v. 1, p. 449.
• Don Patinkin, (1987). "Neutrality of money," The New Palgrave: A Dictionary of Economics, v. 3, pp. 639-44.