Classical dichotomy

Last updated March 20, 2019

In macroeconomics, the classical dichotomy is the idea, attributed to classical 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 rates 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 and other real variables can be determined without knowing the level of the nominal money supply or the rate of inflation. An economy exhibits the classical dichotomy if money is neutral, affecting only the price level, not real variables.^{[ citation needed ]}

Macroeconomics is a branch of economics dealing with the performance, structure, behavior, and decision-making of an economy as a whole. This includes regional, national, and global economies. Macroeconomists study aggregated indicators such as GDP, unemployment rates, national income, price indices, and the interrelations among the different sectors of the economy to better understand how the whole economy functions. They also develop models that explain the relationship between such factors as national income, output, consumption, unemployment, inflation, saving, investment, international trade, and international finance.

Classical economics or classical political economy is a school of thought in economics that flourished, primarily in Britain, in the late 18th and early-to-mid 19th century. Its main thinkers are held to be Adam Smith, Jean-Baptiste Say, David Ricardo, Thomas Robert Malthus, and John Stuart Mill. These economists produced a theory of market economies as largely self-regulating systems, governed by natural laws of production and exchange.

In economics, a real value of a good or other entity has been adjusted for inflation, enabling comparison of quantities as if prices had not changed. Changes in real terms therefore exclude the effect of inflation. In contrast with a real value, a nominal value has not been adjusted for inflation, and so changes in nominal value reflect at least in part the effect of inflation.

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 theories of macroeconomics. In new classical macroeconomics there is a short-run Phillips curve which can shift vertically according to the rational expectations 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.^[1]

The veil of money is the property assumed by some economists whereby money is a commodity like other commodities – such as oil or gold or food – as opposed to its having special properties.

The Phillips curve is a single-equation econometric model, named after William Phillips, describing a historical inverse relationship between rates of unemployment and corresponding rates of rises in wages that result within an economy. Stated simply, decreased unemployment, in an economy will correlate with higher rates of wage rises. Phillips did not himself state there was any relationship between employment and inflation, this notion was a trivial deduction from his statistical findings. Samuelson and Solow made the connection explicit and subsequently Milton Friedman and Edmund Phelps put the theoretical structure in place. In so doing, Friedman was to successfully predict the imminent collapse of Phillips' a-theoretic correlation.

In economics, "rational expectations" are model-consistent expectations, in that agents inside the model are assumed to "know the model" and on average take the model's predictions as valid. Rational expectations ensure internal consistency in models involving uncertainty. To obtain consistency within a model, the predictions of future values of economically relevant variables from the model are assumed to be the same as that of the decision-makers in the model, given their information set, the nature of the random processes involved, and model structure. The rational expectations assumption is used especially in many contemporary macroeconomic models.

Keynesians and monetarists reject the classical dichotomy, because they argue that prices are sticky. That is, they think prices fail to adjust in the short run, so that an increase in the money supply raises aggregate demand and thus alters real macroeconomic variables. Post-Keynesians reject the classic dichotomy as well, for different reasons, emphasizing the role of banks in creating money, as in monetary circuit theory.

Keynesian economics are a group of various macroeconomic theories about how in the short run – and especially during recessions – economic output is strongly influenced by aggregate demand. In the Keynesian view, aggregate demand does not necessarily equal the productive capacity of the economy; instead, it is influenced by a host of factors and sometimes behaves erratically, affecting production, employment, and inflation.

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 national output in the short run and on price levels over longer periods. Monetarists assert that the objectives of monetary policy are best met by targeting the growth rate of the money supply rather than by engaging in discretionary monetary policy.

In microeconomics, the long run is the conceptual time period in which there are no fixed factors of production, so that there are no constraints preventing changing the output level by changing the capital stock or by entering or leaving an industry. The long run contrasts with the short run, in which some factors are variable and others are fixed, constraining entry or exit from an industry. In macroeconomics, the long run is the period when the general price level, contractual wage rates, and expectations adjust fully to the state of the economy, in contrast to the short run when these variables may not fully adjust.

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The IS–LM model, or Hicks–Hansen model, is a macroeconomic tool that shows the relationship between interest rates (ordinate) and assets market. The intersection of the "investment–saving" (IS) and "liquidity preference–money supply" (LM) curves models "general equilibrium" where supposed simultaneous equilibria occur in both the goods and the asset markets. Yet two equivalent interpretations are possible: first, the IS–LM model explains changes in national income when price level is fixed short-run; second, the IS–LM model shows why an aggregate demand curve can shift. Hence, this tool is sometimes used not only to analyse economic fluctuations but also to suggest potential levels for appropriate stabilisation policies.

New Keynesian economics is a school of contemporary macroeconomics that strives to provide microeconomic foundations for Keynesian economics. It developed partly as a response to criticisms of Keynesian macroeconomics by adherents of new classical macroeconomics.

Robert Emerson Lucas Jr. is an American economist at the University of Chicago, where he is currently the John Dewey Distinguished Service Professor Emeritus in Economics and the College. Widely regarded as the central figure in the development of the new classical approach to macroeconomics, he received the Nobel Prize in Economics in 1995 "for having developed and applied the hypothesis of rational expectations, and thereby having transformed macroeconomic analysis and deepened our understanding of economic policy". He has been characterized by N. Gregory Mankiw as "the most influential macroeconomist of the last quarter of the 20th century."

In monetary economics, the quantity theory of money (QTM) states that the general price level of goods and services is directly proportional to the amount of money in circulation, or money supply.

Neo-Keynesian economics is a school of macroeconomic thought that was developed in the post-war period from the writings of John Maynard Keynes. A group of economists, attempted to interpret and formalize Keynes' writings and to synthesize it with the neo-classical models of economics. Their work has become known as the neo-classical synthesis and created the models that formed the core ideas of neo-Keynesian economics. These ideas dominated mainstream economics in the post-war period and formed the mainstream of macroeconomic thought in the 1950s, 1960s and 1970s.

In economics, money illusion, or price illusion, is the tendency of people to think of currency in nominal, rather than real, terms. In other words, the face value of money is mistaken for its purchasing power at a previous point in time. Viewing purchasing power as measured by the nominal value is false, as modern fiat currencies have no intrinsic value and their real value depends purely on the price level.

Neutrality of money is the idea that a change in the stock of money affects only nominal variables in the economy such as prices, wages, and exchange rates, with no effect on real variables, like employment, real GDP, and real consumption. Neutrality of money is an important idea in classical economics and is related to the classical dichotomy. It implies that the central bank does not affect the real economy by creating money. Instead, any increase in the supply of money would be offset by a proportional rise in prices and wages. This assumption underlies some mainstream macroeconomic models. Others like monetarism view money as being neutral only in the long-run.

John B. Taylor Mary and Robert Raymond Professor of Economics at Stanford University

John Brian Taylor is the Mary and Robert Raymond Professor of Economics at Stanford University, and the George P. Shultz Senior Fellow in Economics at Stanford University's Hoover Institution.

The policy-ineffectiveness proposition (PIP) is a new classical theory proposed in 1975 by Thomas J. Sargent and Neil Wallace based upon the theory of rational expectations, which posits that monetary policy cannot systematically manage the levels of output and employment in the economy.

The Lucas islands model is an economic model of the link between money supply and price and output changes in a simplified economy using rational expectations. It delivered a new classical explanation of the Phillips curve relationship between unemployment and inflation. The model was formulated by Robert Lucas, Jr. in a series of papers in the 1970s.

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The new neoclassical synthesis (NNS) or new synthesis is the fusion of the major, modern macroeconomic schools of thought, new classical and Neo-Keynesianism, into a consensus on the best way to explain short-run fluctuations in the economy. The school is also known as New Keynesianism. This new synthesis is analogous to the neoclassical synthesis that combined neoclassical economics with Keynesian macroeconomics. The new synthesis provides the theoretical foundation for much of contemporary mainstream economics. It is an important part of the theoretical foundation for the work done by the Federal Reserve and many other central banks.

References

↑ Galbács, Peter (2015). The Theory of New Classical Macroeconomics. A Positive Critique. Heidelberg/New York/Dordrecht/London: Springer. doi:10.1007/978-3-319-17578-2. ISBN 978-3-319-17578-2.

Roy Green (1987). "Classical theory of money," The New Palgrave: A Dictionary of Economics , v. 1, p. 449.
Don Patinkin, (1987). "Neutrality of money," The New Palgrave: A Dictionary of Economics, v. 3, pp. 639–644.
Huw Dixon, Of Coconuts, decomposition and a Jackass: the genealogy of the Natural Rate, Surfing Economics, Chapter 3.

Don Patinkin was an Israeli/American monetary economist, and the president of Hebrew University in Jerusalem.

Huw David Dixon, born 1958, is a British economist. He has been a professor at Cardiff Business School since 2006, having previously been Head of Economics at the University of York (2003–2006) after being a Professor of economics there (1992–2003), and the University of Swansea (1991–1992), a Reader at Essex University (1987–1991) and a lecturer at Birkbeck College 1983–1987.

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[1] Galbács, Peter (2015). The Theory of New Classical Macroeconomics. A Positive Critique. Heidelberg/New York/Dordrecht/London: Springer. doi:10.1007/978-3-319-17578-2. ISBN 978-3-319-17578-2.