Question

Explain the difference between nominal variables and real variables giving two examples of each. According to the classical dichotomy, which of these two sets of variables are affected by a change in money supply.

Answer 1

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Nominal variables are those which are measured in monetary units while real variables are measured in physical units. A nominal variable is one measured at current prices. Thus if you compare nominal gdp in 2014 with nominal gdp in 2015 the difference is due to both changes in price and volume of gdp. Real variables are volume measures and are measured at constant prices. Thus the change in real gdp between 2014 and 2015 is a pure volume change.

Examples of nominal variables are the wages or income of people, Nominal GDP etc. Examples of real variables are real GDP, quantity of goods produced etc. According to monetary neutrality, the change in money supply affects only nominal variables. Neutrality of money is an important idea in classical economics and is related to the classical dichotomy. It implies that the central bank does not affect the real economy