I n t h I s c h a p t e r y o u w I l L

nominal variables
—variables
measured in monetary units. The second group consists of 
real variables
—vari-
ables measured in physical units. For example, the income of corn farmers is a
nominal variable because it is measured in dollars, whereas the quantity of corn
they produce is a real variable because it is measured in bushels. Similarly, nomi-
nal GDP is a nominal variable because it measures the dollar value of the econ-
omy’s output of goods and services, while real GDP is a real variable because it
measures the total quantity of goods and services produced. This separation of
variables into these groups is now called the 
classical dichotomy.
(A
dichotomy
is a
division into two groups, and 
classical
refers to the earlier economic thinkers.)
Application of the classical dichotomy is somewhat tricky when we turn
to prices. Prices in the economy are normally quoted in terms of money and,
n o m i n a l v a r i a b l e s
variables measured in
monetary units
r e a l v a r i a b l e s
variables measured in physical units
c l a s s i c a l d i c h o t o m y
the theoretical separation of nominal
and real variables

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6 3 4
PA R T T E N
M O N E Y A N D P R I C E S I N T H E L O N G R U N
therefore, are nominal variables. For instance, when we say that the price of corn
is $2 a bushel or that the price of wheat is $1 a bushel, both prices are nominal vari-
ables. But what about a 
relative
price—the price of one thing compared to another?
In our example, we could say that the price of a bushel of corn is two bushels of
wheat. Notice that this relative price is no longer measured in terms of money.
When comparing the prices of any two goods, the dollar signs cancel, and the re-
sulting number is measured in physical units. The lesson is that dollar prices are
nominal variables, whereas relative prices are real variables.
This lesson has several important applications. For instance, the real wage (the
dollar wage adjusted for inflation) is a real variable because it measures the rate at
which the economy exchanges goods and services for each unit of labor. Similarly,
the real interest rate (the nominal interest rate adjusted for inflation) is a real vari-
able because it measures the rate at which the economy exchanges goods and ser-
vices produced today for goods and services produced in the future.
Why bother separating variables into these two groups? Hume suggested that
the classical dichotomy is useful in analyzing the economy because different forces
influence real and nominal variables. In particular, he argued, nominal variables
are heavily influenced by developments in the economy’s monetary system,
whereas the monetary system is largely irrelevant for understanding the determi-
nants of important real variables.
Notice that Hume’s idea was implicit in our earlier discussions of the real
economy in the long run. In previous chapters, we examined how real GDP, sav-
ing, investment, real interest rates, and unemployment are determined without
any mention of the existence of money. As explained in that analysis, the econ-
omy’s production of goods and services depends on productivity and factor sup-
plies, the real interest rate adjusts to balance the supply and demand for loanable
funds, the real wage adjusts to balance the supply and demand for labor, and un-
employment results when the real wage is for some reason kept above its equilib-
rium level. These important conclusions have nothing to do with the quantity of
money supplied.
Changes in the supply of money, according to Hume, affect nominal variables
but not real variables. When the central bank doubles the money supply, the price
level doubles, the dollar wage doubles, and all other dollar values double. Real
variables, such as production, employment, real wages, and real interest rates, are
unchanged. This irrelevance of monetary changes for real variables is called