Classical Dichotomy: Real and Nominal Variables

Real Variables

In macroeconomics, real variables represent the actual behavior of the economy, measured in terms of goods and services, and they reflect the purchasing power of an economy. Some of the most important real variables include real GDP, unemployment, and real wages. These variables are adjusted to exclude the effects of inflation.

Nominal Variables

Nominal variables are those measured in monetary terms or a specific currency. Common examples include nominal wages, the price level, nominal GDP, or the money supply. Unlike real variables, nominal variables are not adjusted for inflation.

Classical Dichotomy

The classical dichotomy posits that in the long run, nominal and real variables are separate. According to this theory, changes in nominal variables, such as the price level or money supply, do not impact real variables like total output or employment. This implies that money is neutral in the long term—in other words, variations in the money supply only affect prices, without altering the real level of production or employment.

In classical economics, an analogy is made comparing nominal variables to a veil. The first thing we see when observing the economy are the nominal variables, but what truly matters are the real variables. Therefore, we need to remove the veil or see through it in order to understand the behavior of real variables and the forces that determine them. In this sense, nominal variables represent an additional challenge for analyzing the real economy.

Criticisms of the Classical Dichotomy

The main criticism of the classical dichotomy comes from Keynesian economists, who argue that in the short run, nominal and real variables are linked. Thus, monetary policy, which is a nominal variable, can influence real variables like unemployment or output. According to the Keynesian school of thought, nominal rigidities and the lack of quick market adjustments can cause changes in nominal variables to affect real variables. These rigidities include factors such as prices being fixed in contracts for a set period, especially wages.