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UNIVERSITY

OF CENTRAL PUNJAB
FINANCIAL ECONOMICS

CLASSICAL DICHOTOMY
SUBMITTED BY:
EMAD TABASSAM
L1F14MSFN0002

SUBMITTED TO:
DR. GHULAM SAGHIR
CLASSICAL DICHOTOMY
The classical dichotomy state that the real variables, like output &
employment, are independent of monetary variables. In this view, the primary
function of money is to act as a emollient for the efficient production and exchange

of commodities. This conception of money rests on real analysis, which describes


an ideal-type economy as a system of barter trade between rational utilitymaximizing individuals.
This is a classical economic concept. The classical dichotomy is, essentially, a
derivation of the quantity theory of money, which is captured by the formula
MV = PY
Where M stands for the money stock, V is the velocity of money circulation, P
is the price level, and Y is the level of income.
The monetary value of output (PY) is thus equal to overall aggregate
monetary expenditure. Exogenous changes in the money supply (M) ultimately
condition the price level for a given level of economic activity. If an economic
system is at full employment, the only effect of increases in the money supply is a
proportionate increase in the domestic price level, which gives rise to a depreciation
of its currencys exchange rate. The direction of causality runs therefore from an
exogenous money supply to the price level.
This is intrinsically connected to the so-called natural rate of interest theory
of New Keynesian economics. A natural rate of interest is determined in the long run
by the equilibrium of savings and investment. This is a full-employment position for
a given economy. A market interest rate that is either above or below this natural
rate is a disequilibrium situation, which is eventually equilibrated through a long-run
process of market clearing.
External changes in the Money Supply are what shift market rates of interest.
This is the process by which discrepancies between market rates and the natural
rate of interest are generated. A market rate of interest below the natural interest
rate occurs when investment exceeds savings. Firms will demand more credit for
investing. The result is an excess of investment over savings. If the economy is at
the full-employment position, defined by the natural rate of interest, a cumulative
process of inflation unfolds. From a heterodox perspective, however, the natural
rate of interest is a conventionally-determined exogenous distributive variable. The
implication is that it is strictly a monetary phenomenon. For a given level of output,
the price level is the result of distributive conflict between capitalists and workers.
Hence, the net impact on the general price level depends on the effects the centralbank determined interest rate exerts on aggregate demand. If a restrictive
monetary policy, via higher market interest rates, leads to a higher price-to-wage
ratio, a lower inflation rate will result if the workers bargaining power is weakened,
ensuing nominal wage reductions.
Further, if conventional rates of interest are artificially set high and effective
demand is not sufficient for businesses to meet profit expectations, and for
governments to afford deficit spending, there is an actual possibility of
unemployment equilibrium. Deflation that is caused by higher real interest rates
does not produce a wealth effect that offsets increased costs of production through
the expansion of consumption. This puts pressure on those entrepreneurs [and
consumers] who are heavily indebted with severely adverse effects on investment.

If the interest rate is set low and is followed suit with appropriate fiscal policy via
aggregate demand management, any so-called burden of private and public debt
accumulation is sustainable, and, as a result, provides impetus for output and
employment expansion.
The classical dichotomy suggests that real variables and monetary variables
are independent of each other. From a unorthodox perspective, by contrast, both
kinds of variables are explained by the relationship established between the central
bank, bank lending, and entrepreneurs animal spirits every time effective
demand is deemed profitable, reversing thereby the causality of the quantitytheory-of-money formula.