"The Classical Dichotomy"

From LibreTexts -- Section 26.2: The Quantity Theory of Money

Prior to the Great Depression, the dominant view in economics was an economic theory called the classical dichotomy. Although this term sounds imposing, the idea is not. According to the classical dichotomy, real variables are determined independently of nominal variables. In other words, if you take the long list of variables used by macroeconomists and write them in two columns—real variables on the left and nominal variables on the right—then you can figure out all the real variables without needing to know any of the nominal variables.

Following the Great Depression, economists turned instead to the aggregate expenditure model to better understand the fluctuations of the aggregate economy. In that framework, the classical dichotomy does not hold. Economists still believe the classical dichotomy is important, but today economists think that the classical dichotomy only applies in the long run.

The classical dichotomy can be seen from the following thought experiment. Start with a situation in which the economy is in equilibrium, meaning that supply and demand are in balance in all the different markets in the economy. The classical dichotomy tells us that this equilibrium determines relative prices (the price of one good in terms of another), not absolute prices.

"If among a nation of hunters," Adam Smith wrote, "it usually costs twice the labour to kill a beaver which it does to kill a deer, one beaver should naturally exchange for or be worth two deer."

Okay, that's relative prices.