Classical dichotomy

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Classical dichotomy

In macroeconomics

Macroeconomics

Macroeconomics is a branch of economics that deals with the performance, structure, and behavior of a national or regional economy as a whole....
, the classical dichotomy refers to an idea attributed to classical

Classical economics

Classical economics is widely regarded as the first modern school of history of economic thought. It is the idea that free markets can regulate themselves....
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 approximately the nominal interest rate minus the inflation rate . Since the inflation rate over the course of a loan is not known initially, Volatility_ in inflation represents a risk to both the lender and the borrower....
s can be completely analyzed without considering what is happening to their nominal counterparts, the money value of output and the interest rate.

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In macroeconomics

Macroeconomics

Classical economics

Real interest rate

Real GDP

Real GDP is a macroeconomic measure of the size of an economy adjusted for price changes and inflation. It measures in constant prices the output of final goods and services and incomes within an economy....
and other real variables can be determined without knowing the level of the nominal money supply

Money supply

In economics, money supply, or money stock, is the total amount of money available in an economy at a particular point in time. There are several ways to define "money", but standard measures usually include currency in circulation and demand deposits....
or the rate of inflation

Inflation

In economics, inflation is a rise in the general price level of goods and services in an economy over a period of time. The term "inflation" once referred to increases in the money supply ; however, economic debates about the relationship between money supply and price levels have led to its primary use today in describing price inflatio...
. An economy exhibits the classical dichotomy if money is neutral

Neutrality of money

In economics, neutrality of money is the idea that a change in the stock of money affects only real versus nominal value variables in the economy such as prices, wages and exchange rates, having no effect on real versus nominal value variables like GDP, employment, and consumption ....
, affecting only the price level, not real variables.

The classical dichotomy was integral to the thinking of 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 The theories forming the basis of Keynesian economics were first presented in The General Theory of Employment, Interest and Money, published in 1936....
and monetarists

Monetarism

Monetarism is a school of economic thought concerning the determination of measures of national income and output and monetary economics. It focuses on the supply of money in an economy as the primary means by which the rate of inflation is determined....
reject the classical dichotomy, because they argue that prices are sticky

Sticky (economics)

Sticky is a term used in the social sciences and particularly economics to describe a situation in which a variable is resistant to change. For example, nominal wages are often said to be sticky....
. That is, they think prices fail to adjust in the short run, so that an increase in the money supply raises aggregate demand

Aggregate demand

In economics, 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....
and thus alters real macroeconomic variables.

Controversy

Don Patinkin

Don Patinkin was an important American economist.Trained at University of Chicago under the tutelage of Oskar Lange and half-participating in the goings-on at the Cowles Commission next door, Don Patinkin emerged as one of the foremost authorities on monetary theory in the post-war years....
(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

Employment

Employment is a contract between two party , one being the #Employer and the other being the #Employee. An employee may be defined as: "A person in the Service of another under any contract of hire, express or implied, oral contract or written, where the employer has the power or right to control and Management the employee i...
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

Comparative statics

In economics, comparative statics is the comparison of two different economic equilibrium states, before and after a change in some underlying exogenous parameter....
analysis can be performed using a jacobian

Jacobian

In vector calculus, the Jacobian is shorthand for either the Jacobian matrix or its determinant, the Jacobian determinant.In algebraic geometry the Jacobian of a algebraic curve means the Jacobian variety: a group variety associated to the curve, in which the curve can be embedded....
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

Matrix (mathematics)

In mathematics, a matrix is a rectangular array of numbers, as shown at the right. In addition to a number of elementary, entrywise operations such as matrix addition a key notion is matrix multiplication....
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.