Question

Explain the following terms:

(i) Classical dichotomy

(ii) Impossible trinity

Answer 1

1) The Neutrality of money is a neoclassical theory claiming that the money supply has no effect on real variables (e.g. real GDP and employment) - it only has on nominal variables (e.g. prices, wages, exchange rates). It is part of the broader concept of Classical dichotomy. The neutrality of money is the justification for those claiming that monetary policy would have no impact on economic output and employment, and would only influence prices. Keynes attacked this claim and noted that prices are sticky in the short-run (a claim which has been validated by a plethora of empirical evidence) and do not adjust quickly and immediately to changes in the money supply. This gives monetary policymakers some lee way to influence real variables in the short-run, although their efforts would be more ineffective in the long-run.

2) Basically, impossible trinity can be defined as the three policy options or choices that the policy makers or national govts can't opt for all at a time. These three are -free capital flows, fixed exchange rate, and independent monetary policy. All the three choices can't exist simultaneously,making it an impossible trinity. Only two of them can coexist with each other. It's possible to depict the doctrine with the help of a simple triangle. Let's assume that independent money policy and fixed exchange rate r depicted by the two base corners of the ? and free capital flows by the upper corner of the same. Thus only one side of the triangle is possible, either free capital flows and independent money policy, either independent money policy and fixed exchange rate, or fixed exchange rate and free capital flows.