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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: