Question

Question 5.

a. Explain the concepts of classical dichotomy and neutrality of money.

b. Based on your knowledge of the materials in chapter 4, 5, and 6 of your text, give three examples of theories where classical dichotomy holds. In each case explain how classical dichotomy holds

Answer 1

The neutrality of money, also called neutral money, says changes in the money supply only affect nominal variables and not real variables. In other words, an increase or decrease in the money supply can change the price level but not the output or structure of the economy. In modern versions of money neutrality theory, changes in the money supply might affect output or unemployment levels in the short run only, but neutrality is still assumed in the long run after money circulates throughout the economy.

when the Federal Open MarketCommittee (an agency within the Federal Reserve) purchases U.S. Treasurys in the open market, it gives money to the sellers. The sellers deposit these payments at their local banks. Because the Federal Reserve requires banks to maintain a certain percentage of these deposits in reserve, the banks are free to lend most of these new deposits to other bank customers and earn interest. These customers in turn deposit the loan proceeds in their own bank accounts, and the process continues indefinitely. Thus, every dollar of securities that the Federal Reserve buys increases the money supply by several dollars.

There are only two things to do with money: save it or spend it. Accordingly, some of the "new" money in the economy (from the Treasury repurchase) will land in bank accounts, and some of the new money willland in the hands of retailers, service providers, new employees, etc. This increase in the demand for goods and services willdrive the prices of those goods and services up. The increased demand may also encourage employers to hire more employees, and the demand for more employees also drives wages up.

However, the neutrality of money theory says that the ripple effect essentially stops there. In other words, the repurchase would not increase the productivity of the economy's employees and may not increase the country's gross domestic product (GDP).