Classical Dichotomy

Updated Jan 20, 2023

Definition of Classical Dichotomy

The classical dichotomy is a theoretical economic concept that states that real variables (e.g., output, employment, and real interest rates) and nominal variables (e.g., money supply and money demand) are independent of each other. That means changes in nominal variables do not affect real variables and vice versa. This concept is attributed to classical and pre-Keynesian economics. However, it is mostly rejected by monetarists, Keynesians, and post-Keynesians, albeit for different reasons. While the former argue that prices are sticky, the latter refer to the role of banks in creating money to show that money supply (i.e., a nominal variable) can directly affect real GDP (i.e., a real variable) and is therefore not neutral.

Example

To illustrate the concept of classical dichotomy, let’s look at a hypothetical economy with a fixed money supply. This economy is operating at full-employment levels, and the total money supply is fixed at USD 100. Now, imagine the monetary authority (i.e., the central bank) decides to increase the money supply to USD 200. According to the classical dichotomy, this increase in the money supply should not affect the real variables in the economy because everything else still stays the same. That means while the price level would increase (due to inflation), the output, as measured by the real GDP, employment rates, real wages, and real interest rates should remain unaffected from the increase in the money supply both in the short and in the long run.

Why the Classical Dichotomy Matters

The Classical Dichotomy is an important classical concept in economics because it helps us to understand how the economy works. It states that changes in the money supply do not affect real variables and vice versa. This means that central banks can use monetary policy to influence the money supply without affecting the real variables in the economy. This is important because, in theory, it allows policymakers to control inflation without affecting output, employment, and prices.