Classical economics held that the two types of economic variables, nominal and real, exist independently, resulting in this dichotomy of the Classical model. Classical economist Pigou compared this characteristic of nominal capital to a “veil” necessary to look beyond to find the real forces propelling the economy. Money is just a tool to facilitate the barter within an economy and it influences merely the nominal price level and the level of money wages. The nominal money stock has no true affect on real variables, such as output, real interest rates and unemployment, or the real health of the economy. The Classical interpretation gives little importance for the government and its ability to manage the economy. For instance, if the Central Bank prints more money thus doubling the money supply and causing inflation, the level of outputs will double accordingly. Classical thinkers reasoned that the real value of money is essentially the quantity of real goods which it can purchase. Thus, the real wage level, the amount of output the consumer will actually be able to buy for his nominal money; will remain unchanged as increasing price levels follow the increase in money supply until equilibrium is reached once again. Or rather, expenditure on goods is increased as a result of excess capital until the balance price level is reached and excess demand is satisfied; resulting in the new equilibrium.
Although this theory of pure monetary neutrality may work in the long run, when the economy has had sufficient time to adjust labor and production to reach market-clearing equilibrium; it is bound to fail in the short run. The comparative static analysis of the Classical model contrasts between different positions of equilibrium, arising from a shift in some parameter. The resulting disequilibrium must then be balanced out until a new equilibrium is reached by an adjustment in some other variable. This is the point where the Classic theory of pure monetary neutrality fails. Although it may work splendidly in the long run, when the economy has had sufficient time to adjust labor and production to reach market-clearing equilibrium; it is bound to fail in the short run. Classical economists already noted that the Classical, static, model does not count for this laps time or dynamic period until equilibrium is reached. Adjustment in the market is unrealistically assumed to be automatic and immediate, causing a temporary disequilibrium and the resulting inadequacy of this model in the short run. There are a variety of impediments to the automatic adjustment of variables, such as insufficiently responsive prices to changes in the and . Prices’ reluctance to change, often called “sticky prices”, are caused by inadequate information, consumers’ resistance to frequent price changes and long-term contracts with fixed prices. Inflation, or the change in the nominal value of the money stock, does affect the real economy in the short run, as consumers may be mislead by “money illusion”. People may have the false sense that they are getting richer at times of inflation, when in fact only the nominal value of money is increasing. Consumers are lulled by the idea that their wages are increasing, when perhaps in inflation-adjusted terms they may not be better off. The Keynesian term “money illusion” encourages people to spend more and may help gear the economy out of recession.
The Classical economists believed in a static, self-correcting system which divides the economy into two independent groups of variables; the nominal and the real. Only real variables have an effect on the real functioning and health of the economy. Their theory is limited to the long term as they fail to account for the dynamic periods in between market equilibriums. In a closed economic model the Central Bank could determine the quantity of money in the market. However, it is the public who determines its real value through spending or saving it. Furthermore, in today’s realities economies are open and increasingly linked to the rest of the world through international trade. The Central Bank would have difficulty affecting even the nominal quantity of money in its home-market system unless its economy was significant enough to influence on its own the world price level. Excess money in open markets disappears down the “foreign drain” or is sucked up by foreign markets. When considering the Classical model and its implications for to the contemporary world, we also need to look at the most opposing view, or Keynesian economics. While the Classical model stresses that markets will always perfectly clear and government should do nothing more than safeguard the functioning of these market processes Keynes argues that markets need to helped with a combination of monetary and fiscal policies. The question remains, how effective is government spending in curbing periods of disequilibrium in the economy?
References
Monetary Neutrality, “Economics A-Z.” Retrieved from The Economist database on 13/02/2006 at <>
Mundell, R. “International Economics.” New York: Macmillan, 1968.
Shaw, G., McCrostie, J. & Greenway, D. “Macroeconomics: Theory and Policy in the UK.” 3rd ed. Oxford: Blackwell, 1997.
Hillier, B. “The Macroeconomic Debate.” Oxford: Blackwell, 1991.