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 utility-maximizing 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 currency’s 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 central-bank 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 quantity-theory-of-money formula.