3. The classical dichotomy and the neutrality of money The classical dichotomy i

Question

3. The classical dichotomy and the neutrality of money The classical dichotomy is the separation of real and nominal variables. The following questions test your understanding of this distinction Juanita spends all of her money on comic books and beignets. In 2011, she earned $14.00 per hour, the price of a comic book was $7.00, and the price of a beignet was $1.00. Which of the following give the nominal value of a variable? Check all that apply The price of a beignet is o.14 comic books in 2011. Juanita's wage is $14.00 per hour in 2011 Juanita's wage is 2 comic books per hour in 2011 Which of the following give the real value of a variable? Check all that apply The price of a comic book is $7.00 in 2011 Juanita's wage is 14 beignets per hour in 2011 Juanita's wage is $14.00 per hour in 2011

Explanation / Answer

Solution:

Nominal value of a variable is the value not adjusted for price, so it is a numeric value which doesn't talks about the purchasing power, or in relative terms but in absolute terms. Real value is the opposite, i.e, a value adjusted for price, to keep the purchasing power constant mostly.

Q1: First option tells price of beignet, relative to comic books, thus it isn't a nominal value

Second option talks in absolute terms the wage rate of Juanita, so it is a nominal value of the variable.

In third option, again wage is talked in relative terms of comic books, depicting the purchasing power of Juanita, so it isn't a nominal value.

Q2: First option tells the price in absolute terms and not in relative terms, so this isn't real value.

Second options tells the value of wage relative to beignet, i.e, the amount og beignets that can be bought with the money. Since, it tells the purchasing power, it is a real value.

Third option is again the wage in abolute terms, this money value is nominal value and not real value.

Q3: Initial wage = $14 per hour, new wage = $28 per hour. Initial prices of comic book = $7, beignet= $1. New prices of comic book = $14, beignet = $2.

In 2016 relative price of comic book is the amount of beignets that could be bought in it's place which is = 14/2 = 7 beignets

Clearly, nominal value Juanita's wage has increased (from $14 to $28). As told above, real values are found after adjusting for price. In 2016 the prices are 2x the prices in 2011, so the general price level has increased 2 times. Also, the wage has increased 2 times.

Real value of wage (in 2011) = nominal value of wage in 2011/nominal value of price in 2011.

Real value of wage (in 2016) = nominal valueof wage in 2016/price level in 2016 = (2*initial nominal value(in 2011))/(2*initial price level(in 2011)) = nominal value of wage in 2011/nominal value of price in 2011.

So, real value of wage in 2011 = real value of wage in 2016, or in other terms, the real value of her wage has remained same (not changed).

This is the concept of money neutrality. It is the proposition that a change in the money supply changes (in our example, increased) nominal variables, and doesn't change real variables.

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