Classical dichotomy

The classical dichotomy is a fundamental concept in macroeconomics that suggests the separation of real and nominal variables in an economy.
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Updated on Jun 5, 2024
Reading time 2 minutes

3 Key Takeaways

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  • Real variables are determined by real factors (e.g., productivity, technology).
  • Nominal variables are determined by the quantity of money.
  • The theory proposes that changes in the money supply affect nominal variables (prices) but not real variables (output, employment).

What is Classical Dichotomy?

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In economic theory, the classical dichotomy is the idea that real variables, like output, employment, and real interest rates, are independent of monetary factors. This concept asserts that changes in the money supply only affect nominal variables, such as prices and wages, while leaving real variables unchanged in the long run.

Importance of Classical Dichotomy

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  • Simplifies Economic Analysis: By separating real and nominal variables, economists can analyze economic phenomena more easily, focusing on the underlying real forces.
  • Policy Implications: The theory suggests that monetary policy can only influence inflation in the long run, but not real economic growth.
  • Theoretical Foundation: It forms the basis for many classical and neoclassical economic models.

How Classical Dichotomy Works

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The classical dichotomy operates under the assumption of money neutrality. In the long run, an increase in the money supply is believed to proportionally increase all prices and wages, leaving relative prices and real variables unchanged. For example, doubling the money supply would double prices, but it wouldn’t affect the real output of goods and services or the real wage rate.

Examples of Classical Dichotomy

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  • Hyperinflation: During periods of hyperinflation, prices rise rapidly due to a massive increase in the money supply. However, real output may not necessarily increase.
  • Economic Growth: Technological advancements or increases in labor productivity can lead to real economic growth, independent of changes in the money supply.

Real World Application of Classical Dichotomy

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While the classical dichotomy provides a useful framework for understanding long-run economic relationships, it has been challenged by some economists who argue that money is not always neutral in the short run. In reality, there may be some short-term effects of monetary policy on real variables, particularly during economic downturns. However, the classical dichotomy remains a key concept in macroeconomics and continues to shape economic policy discussions.


Sources & references

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