macroeconomics Macroeconomics (from the Greek prefix ''makro-'' meaning "large" + ''economics'') is a branch of economics dealing with performance, structure, behavior, and decision-making of an economy as a whole. For example, using interest rates, taxes, and ...

, the classical dichotomy is the idea, attributed to classical and pre-

Keynesian Keynesian economics ( ; sometimes Keynesianism, named after British economist John Maynard Keynes) are the various macroeconomic theories and models of how aggregate demand (total spending in the economy) strongly influences economic output an ...

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 The real interest rate is the rate of interest an investor, saver or lender receives (or expects to receive) after allowing for inflation. It can be described more formally by the Fisher equation, which states that the real interest rate is approx ...

s 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 Real gross domestic product (real GDP) is a macroeconomic measure of the value of economic output adjusted for price changes (i.e. inflation or deflation). This adjustment transforms the money-value measure, nominal GDP, into an index for quantity ...

and other real variables can be determined without knowing the level of the nominal

money supply In macroeconomics, the money supply (or money stock) refers to the total volume of currency held by the public at a particular point in time. There are several ways to define "money", but standard measures usually include Circulation (curren ...

or the rate of

inflation In economics, inflation is an increase in the general price level of goods and services in an economy. When the general price level rises, each unit of currency buys fewer goods and services; consequently, inflation corresponds to a reductio ...

. An economy exhibits the classical dichotomy if money is

neutral Neutral or neutrality may refer to: Mathematics and natural science Biology * Neutral organisms, in ecology, those that obey the unified neutral theory of biodiversity Chemistry and physics * Neutralization (chemistry), a chemical reaction in ...

, affecting only the price level, not real variables. As such, if the classical dichotomy holds, money only affects absolute rather than the relative prices between goods. 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 New classical macroeconomics, sometimes simply called new classical economics, is a school of thought in macroeconomics that builds its analysis entirely on a neoclassical framework. Specifically, it emphasizes the importance of rigorous foundat ...

theories of macroeconomics. In new classical macroeconomics there is a short-run

Phillips curve The Phillips curve is an economic model, named after William Phillips hypothesizing a correlation between reduction in unemployment and increased rates of wage rises within an economy. While Phillips himself did not state a linked relationship ...

which can shift vertically according to the

rational expectations In economics, "rational expectations" are model-consistent expectations, in that agents inside the model A model is an informative representation of an object, person or system. The term originally denoted the plans of a building in late 16 ...

being reviewed continuously. In the strict sense, money is not neutral in the short-run, that is, classical dichotomy does not hold, since agents tend to respond to changes in prices and in the quantity of money through changing their supply decisions. However, money should be neutral in the long run, and the classical dichotomy should be restored in the long-run, since there was no relationship between prices and real macroeconomic performance at the data level. This view has serious economic policy consequences. In the long-run, owing to the dichotomy, money is not assumed to be an effective instrument in controlling macroeconomic performance, while in the short-run there is a trade-off between prices and output (or unemployment), but, owing to rational expectations, government cannot exploit it in order to build a systematic countercyclical economic policy.

Keynesians Keynesian economics ( ; sometimes Keynesianism, named after British economist John Maynard Keynes) are the various macroeconomic theories and models of how aggregate demand (total spending in the economy) strongly influences economic output an ...

and

monetarists Monetarism is a school of thought in monetary economics that emphasizes the role of governments in controlling the amount of money in circulation. Monetarist theory asserts that variations in the money supply have major influences on nationa ...

reject the classical dichotomy, because they argue that prices are

sticky Sticky may refer to: People *Sticky (musician), alias of UK garage producer Richard Forbes * Sticky Fingaz or Sticky (born 1973), nickname of the US rapper and actor Kirk Jones Adhesion *Adhesion Adhesion is the tendency of dissimilar ...

. That is, they think prices fail to adjust in the

short run In economics, the long-run is a theoretical concept in which all markets are in equilibrium, and all prices and quantities have fully adjusted and are in equilibrium. The long-run contrasts with the short-run, in which there are some constraints a ...

, so that an increase in the money supply raises

aggregate demand In macroeconomics, aggregate demand (AD) or domestic final demand (DFD) is the total demand for final goods and services in an economy at a given time. It is often called effective demand, though at other times this term is distinguished. This is ...

and thus alters real macroeconomic variables.

Post-Keynesians Post-Keynesian economics is a school of economic thought with its origins in ''The General Theory'' of John Maynard Keynes, with subsequent development influenced to a large degree by Michał Kalecki, Joan Robinson, Nicholas Kaldor, Sidney We ...

reject the classic dichotomy as well, for different reasons, emphasizing the role of banks in creating money, as in monetary circuit theory.

References

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References

Further reading