Question

What is the classical dichotomy theory and what is its importance for the AD-AS model?

Answer 1

Classical dichotomy refers to the theoretical separation of real and nominal variables . Classical economists believed in neutrality of money , they argued that monetary developments effect only nominal variables , real variables remain unchanged .

Since wages and prices are sticky in short run , so classical dichotomy does not hold in short run . The AD/AS model tells us that changes in nominal variables or monetary changes causes change in real variables also ( real GDP ) in short run . But in long run due to vertical or inelastic aggregate supply curve the classical dichotomy holds . The potential real GDP is unchanged in long run even if price level changes .