We have finished our discussion of money and inflation. Let’s now step back and examine a key assumption that has been implicit in our discussion.

In Chapter 3, we explained many macroeconomic variables. Some of these variables were quantities, such as real GDP and the capital stock; others were relative prices, such as the real wage and the real interest rate. But all of these variables had one thing in common—they measured a physical (rather than a monetary) quantity. Real GDP is the quantity of goods and services produced in a given year, and the capital stock is the quantity of machines and structures available at a given time. The real wage is the quantity of output a worker earns for each hour of work, and the real interest rate is the quantity of output a person earns in the future by lending one unit of output today. All variables measured in physical units, such as quantities and relative prices, are called real variables.

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In this chapter we examined nominal variables—variables expressed in terms of money. The economy has many nominal variables, such as the price level, the inflation rate, and the dollar wage a person earns.

At first it may seem surprising that we were able to explain real variables without introducing nominal variables or the existence of money. In Chapter 3, we studied the level and allocation of the economy’s output without mentioning the price level or the rate of inflation. Our theory of the labour market explained the real wage without explaining the nominal wage.

Economists call this theoretical separation of real and nominal variables the classical dichotomy. It is the hallmark of classical macroeconomic theory. The classical dichotomy is an important insight because it greatly simplifies economic theory. In particular, it allows us to examine real variables, as we have done, while ignoring nominal variables. The classical dichotomy arises because, in classical economic theory, changes in the money supply do not influence real variables. This irrelevance of money for real variables is called monetary neutrality. For many purposes—in particular for studying long-run issues—monetary neutrality is approximately correct.

Yet monetary neutrality does not fully describe the world in which we live. Beginning in Chapter 9, we discuss departures from the classical model and monetary neutrality. These departures are crucial for understanding many macro-economic phenomena, such as short-run economic fluctuations.