What is the Classical dichotomy? Under what circumstances of disequilibrium did the Classical economist accept that the dichotomy does not hold?

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What is the Classical dichotomy? Under what circumstances of disequilibrium did the Classical economist accept that the dichotomy does not hold?

Selfishness is a reprehensible human characteristic; yet it is precisely the necessary behavior yielding the greatest possible economic benefit for the entire society according to Classical economics.  The dominant economic theory from the 18th to 20th century was of a free market system of continuous competitive exchange equilibrium in which prices and output regulate themselves perfectly until markets achieve the market-clearing price.  The Classical system takes place in a closed economy which spontaneously moves toward full-employment equilibrium.  The principle fueling such a system is that money wages are flexible, and the employment equilibrium is not affected by the “nominal” amount of money in this dichotomous system.  However, there are limitations to the Classical model; mainly that it does not work in the short-run because it fails to account for market dynamism.  The theory assumes automatic adjustment of markets from one equilibrium to the next and ignores periods of change, or disequilibrium.  Although a static model like the Classic has its downfalls, it is in important indicator of market forces, and is once again gaining popularity as a “Neo-classical” model after its long refutation by Keynesian economists.

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Classical economics held that the two types of economic variables, nominal and real, exist independently, resulting in this dichotomy of the Classical model.  Classical economist Pigou compared this characteristic of nominal capital to a “veil” necessary to look beyond to find the real forces propelling the economy.  Money is just a tool to facilitate the barter within an economy and it influences merely the nominal price level and the level of money wages.  The nominal money stock has no true affect on real variables, such as output, real interest rates and unemployment, or the real health of the economy. ...

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