The classical dichotomy and monetary neutrality are represented graphically by

The Neutrality of Money and Classical Dichotomy!

The classical theory of output and employment is that changes in the quantity of money affect only nominal variables (i.e. money wages, nominal GNP, money balances), and have no influence whatsoever on the real variables of the economy such as real GNP (i.e. output of goods and services produced), level of employment (i.e. number of labour – hours or number of workers employed), real wage rate (i.e. wage rate in terms of its purchasing power).

Actually, according to classical theory, the nominal variables move in proportion to changes in the quantity of money, while real variables such as GNP, employment, real wage rate, real rate of intrest remain unaffected.

Classical economists explained that real variables such as GNP, employ­ment, real wage rate are determined by real factors such as stock of capital, the state of technology, marginal physical product of labour, households’ preferences regarding work and leisure.

In the classical model based on flexibility of prices and wages, changes in money supply only affect the price level and nominal magnitudes (i.e. money wages, nominal interest rate, while the real variables such as levels of labour employment and output, saving and investment, real wages, real rate of interest remain unaffected. This independence of real variables from changes in money supply and nominal variables is called classical dichotomy.

The neutrality of money can be graphically illustrated with the help Fig. 3.7 and 3.8. Suppose to begin with, the stock of money in the economy is equal to M0. With this, as will be seen from Panel (d) of Figure 3.7, aggregate demand curve for output is AD0 which with interaction with aggregate sup­ply curve AS determines price level P0. Given the price level P0, labour-market equilibrium determines money wage rate W0 and real wage rate equal to W0 / P0 and level of employment NF in Panel (a) of Fig. 3.7. The level of employment NF given the production function, determines aggregate output YF. in Panel (b) of Fig. 3.7.

Now suppose there is expansion in money supply from M0 to M1 which causes an upward shift in the aggregate demand curve from AD0 to AD1 [see Panel (d) of Fig. 3.7], As a result of this upward shift in the aggregate demand curve from AD0 to AD1 price level rises from P0 to P1 Now, as will be seen from Panel (a) of Fig. 3.7, with money wage rate W0 and price level equal to P1, real wage rate falls to W0/ P1

at which demand for labour exceeds supply of labour. This will cause, according to classical theory, money wage rate to rise to W1 in equal proportion to the rise in price level so that real wage is restored to the original level (W1/P1 = W0/P0) and labour-market equilibrium determines the original level of employment N1.

With the same level of labour employment aggregate output (i.e. GNP) will not be affected. Thus, we see that with the expansion in money supply, nominal wage rate and price level have risen, but real wage rate, level of employment and output remain constant. Hence it shows that money is neutral in its effect on real variables.

Changes in Money Supply, Saving-Investment Equilibrium and Neutrality of Money:

Accord­ing to the classical theory, money performs the function of merely a medium of exchange of goods and services and is therefore demanded only for transaction purposes. This means alternative to holding money is the purchase of goods and services.

Therefore, demand for and supply of money in the classical system does not determine the rate of interest. When the quantity of money increases, it will leave the real rate of interest unchanged and hence the amount of output saved and allocated to investment (i.e., real saving and investment) will remain the same as shown in Fig. 3.8.

This means the increase in money supply does not disturb the capital market equilibrium or saving-investment equality and consequently the continuation of full-employment equilibrium. However, it may be noted that the higher level of prices of commodities would mean that investment expenditure in money terms will increase in the same propor­tion as the rise in prices even though the output of commodities allocated for investment pur­poses remains the same.

But this increase in monetary expenditure for investment is matched by the equal increase in monetary saving brought about by the rise in prices. The higher prices of commodities also mean a proportionate increase in the amount of money received from the sale of commodities so that savers are willing to pro­vide proportionately larger amount of saving at a given rate of interest.

Thus, with the increase in quantity of money, the supply curve of nomi­nal saving and investment demand curve will shift to the right as shown by dotted S’S’ and IT curves by the same proportion so that the same real rate of interest is maintained and the same amounts of real saving and investment in terms of commodities are made at the higher price level.

A serious limitation of the classical concept of neutrality of money may be noted. As seen above, the neutrality of money is a basic result reached in the classical full-employment model based on flexibility of prices and wages. If increase in money supply and consequent rise in prices has no real effects, then inflation would not be a matter of concern.

However, we know that inflation is a matter of serious concern as it lowers standards of living of the people and also adversely affects economic growth. Therefore, efforts are made to control inflation and achieve price stability in the economy.