Question

We have noted that the classical dichotomy assumption holds in the long run but not in the short

run.

a. Briefly describe 3 reasons why the classical dichotomy would not hold in the short-run

b. If we assume that the classical dichotomy holds in the short run as well, what effect

would changes in the nominal interest rate have on the real economy?

Answer 1

a)Classica dichotomy is a situation which happens in classical economy or in pre-keynsian economy. This dichotomy is nominal variables does not affect real variables. The real variables like output, real interest rate can be analysed without considering nominal variables. The classical dichotomy does not hold in short run because of following reasons:

i) Due to imperfect information and costly computation the firms do not update the prices immediately. It takes some time to adjust to change in nominal wages and prices. In short run it is not possible. So real variables does not change in same proportion as nominal variables.

ii) The contracts of wages and prices are set in nominal terms not in real terms. So these contracts prevent these changes immediately. So nominal value do not change immediately. In short run it is not possible to change.

iii) There is bergaining cost of negotiating prices and wages. So because of this bergaining cost the real and nominal variables do not change immediately.

iv) The money illusion work sometimes. Because people focus more on nominal variables rather than real variables.

b) If we assume classical dichotomy holds in short run it means nominal interest does not affect real interest rate. So if nominal interest rate changes then real interest rate will not change in classical dichotomy. If real interest rate does not changes then economy will not show the exact situation. It means real interest rate and real output let suppose. If real interest rate not changes then real output will not change and as a result the real output will not change. So LM curve will be vertical. Because real output will be fixed though nominal rate changes. But in general LM curve is upward sloping.