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Classical Dichotomy

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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 money, as in monetary circuit theory.

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

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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

J = 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: