The classical relationship between money supply and price level can be illustrated in terms of Fig. Due to the classical dichotomy, a change in the money supply will not affect interest rates. How can the Classical Model be used today. They are interested only in the real value of their cash holdings. According to Patinkin, the real balance implies that people do not suffer from ‘money illusion’. Introduction: After Keynes, a neoclassical theory of investment has been developed to explain investment behaviour with regard to fixed business investment. Besides removing the classical dichotomy and integrating the monetary and value theory through the real balance effect, Patinkin also validates the quantity theory conclusion. The Phillips Curve shows that wages and prices adjust slowly to changes in AD due to imperfections in the labour market. Real income is income of individuals or nations after adjusting for inflation.It is calculated by dividing nominal income by the price level. ADVERTISEMENTS: The quantity theory of money states that price level is a function of the supply of money. Classical Monetary Thought Thomas M. Humphrey Introduction The rise of the new classical macroeconomics, with its key idea that systematic monetary policy cannot influence real activity, has revived interest in the so-called classical neutrality postulate. Most importantly, real-business-cycle theory holds that the economy obeys the classical dichotomy nominal variables are assumed not to influence real variables. 2. It assumes an increase in money supply creates inflation and vice versa. At this point, it should be mentioned that the classical model was not held in its entirety by any economist. ADVERTISEMENTS: Let us make in-depth study of the Neoclassical theory of investment in an economy. It is to determine the general level of prices at which goods and services will be exchanged. This theory is called neoclassical theory of investment behaviour because it is based on the neoclassical theory of optimal […] 13.7). e.g. Money Classical dichotomy (money is neutral) ‘money matters’ (has real effects) unemployment Voluntary or due to rigidities Involuntary, due to lack of demand on goods markets policy Laissez faire: markets are self-regulating and gov’t should not intervene market economies are unstable and result in unemployment → Fig. In the classical system, the main function of money is to act as a medium of exchange. To explain fluctuations in real variables, real-business-cycle theory emphasis real changes in the economy, such as changes in fiscal policy and production technologies. The quantity theory of money is a framework to understand price changes in relation to the supply of money in an economy. 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