Classical dichotomy

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The classical dichotomy theory refers to the division between real and nominal variables in economics. Real variables such as output, unemployment, or real interest rates do not necessarily have to be influenced by changes in nominal variables, as most importantly the nominal money supply. Changes in the money supply therefore do not - according to the strict dichotomy - influence real variables (monetary neutrality). The classical dichotomy was central to the thinking of early economists (money as a veil).

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 (employment, growth). Patinkin postulated that this inflation could not come about without a corresponding disturbance in the goods market, through the 'real balance effect'. 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 - the price adjustment was assumed to be immediate - the 'invisible hand'.

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.

[edit] Mathematical properties

A classical dichotomy is exhibited when the jacobian matrix of the series equations Jdy = dx is block recursive in nature. In other words, you should be able to solve for all real variables without having to solve for money.