THE ASSUMPTIONS OF ClASSICAl ECONOMICS

In previous chapters, we developed theories to explain what determines most important macroeconomic variables in the long run. Chapter 25 explained’ the level and growth of productivity and real GDP.

Chapters 26 and 27 explained how the financial system works and how the real interest rate adjusts to balance saving and investment. Chapter 28 explained why there is always some unemployment in the economy. Chapters 29 and 30 explained the monetary system and how changes in the money supply affect the price level, the inflation rate, and the nominal interest rate. Chapters 31 and 32 extended this analysis to open economies to explain the trade balance and the exchange rate.

All of this previous analysis was based on two related ideas: the classical dichotomy and monetary neutrality. Recall that the classical dichotomy is the separation of variables into real variables (those that measure quantities or relative prices) and nominal variables (those measured in terms of money).

According to classical macroeconomic theory, changes in the money supply affect nominal variables but not real variables. As a result of this monetary neutrality, Chapters 25 through 28 were able to examine the determinants of real variables (real- GDp, the real interest rate, and unemployment) without introducing  nominal variables (the money supply and the price level).

In a sense, money does not matter in a classical world. If the quantity of money in the economy were to double, everything would cost twice as much, and everyone’s income would be twice as high. But so what? The change would be nominal (by the standard meaning of «nearly insignificant”). The things that people really care about-whether they have a job, how many goods and services they can afford, and so on would be exactly the same.

This classical view is sometimes described by the saying.Money is a veil. That is, nominal variables may be the first things we see when we observe an economy because economic variables are often expressed in units of money: But what’s important are the real variables and the economic forces that determine them. According to classical theory, to understand these real variables, we need to look beneath the veil.