Over the course of this and the previous chapter, we have studied the meaning of money and the impact of the money supply on inflation and various other variables. This analysis builds on our model of national income in Chapter 3. 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—
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 labor 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 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 in the determination of real variables is called monetary neutrality. For many purposes—
Yet monetary neutrality does not fully describe the world in which we live. Beginning in Chapter 10, we discuss departures from the classical model and monetary neutrality. These departures are crucial for understanding many macroeconomic phenomena, such as short-