Macroeconomics

4-7

Conclusion: The Classical Dichotomy

We have finished our discussion of money and inflation. Let’s now step back and

examine a key assumption that has been implicit in our discussion.

In Chapter 3, we explained many macroeconomic variables. Some of these

variables were quantities, such as real GDP and the capital stock; others were

relative prices, such as the real wage and the real interest rate. But all of these

variables had one thing in common—they measured a physical (rather than a

monetary) quantity. Real GDP is the quantity of goods and services produced

in a given year, and the capital stock is the quantity of machines and struc-

tures available at a given time. The real wage is the quantity of output a work-

er earns for each hour of work, and the real interest rate is the quantity of

output a person earns in the future by lending one unit of output today. All

variables measured in physical units, such as quantities and relative prices, are

called real variables.

In this chapter we examined nominal variables—variables expressed in

terms of money. The economy has many nominal variables, such as the price

level, the inflation rate, and the dollar wage a person earns.

At first it may seem surprising that we were able to explain real variables with-

out introducing nominal variables or the existence of money. In Chapter 3 we

studied the level and allocation of the economy’s output without mentioning the

price level or the rate of inflation. Our theory of the labor market explained the

real wage without explaining the nominal wage.

Economists call this theoretical separation of real and nominal variables the