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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?

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Introduction

Edit Sipos Supervision 1, Macro 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. ...read more.

Middle

Or rather, expenditure on goods is increased as a result of excess capital until the balance price level is reached and excess demand is satisfied; resulting in the new equilibrium. Although this theory of pure monetary neutrality may work in the long run, when the economy has had sufficient time to adjust labor and production to reach market-clearing equilibrium; it is bound to fail in the short run. The comparative static analysis of the Classical model contrasts between different positions of equilibrium, arising from a shift in some parameter. The resulting disequilibrium must then be balanced out until a new equilibrium is reached by an adjustment in some other variable. This is the point where the Classic theory of pure monetary neutrality fails. Although it may work splendidly in the long run, when the economy has had sufficient time to adjust labor and production to reach market-clearing equilibrium; it is bound to fail in the short run. Classical economists already noted that the Classical, static, model does not count for this laps time or dynamic period until equilibrium is reached. ...read more.

Conclusion

Only real variables have an effect on the real functioning and health of the economy. Their theory is limited to the long term as they fail to account for the dynamic periods in between market equilibriums. In a closed economic model the Central Bank could determine the quantity of money in the market. However, it is the public who determines its real value through spending or saving it. Furthermore, in today's realities economies are open and increasingly linked to the rest of the world through international trade. The Central Bank would have difficulty affecting even the nominal quantity of money in its home-market system unless its economy was significant enough to influence on its own the world price level. Excess money in open markets disappears down the "foreign drain" or is sucked up by foreign markets. When considering the Classical model and its implications for to the contemporary world, we also need to look at the most opposing view, or Keynesian economics. While the Classical model stresses that markets will always perfectly clear and government should do nothing more than safeguard the functioning of these market processes Keynes argues that markets need to helped with a combination of monetary and fiscal policies. ...read more.

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