classical dichotomy refers to which one of the following?

(1) There are two sectors of the economy, namely agriculture and industry

(2)Influence of money is not on the real variables like employment and output but on pricelevel

(3) Savings come only from profits and not from the wages

Answer: (2) The concept of classical dichotomy explains the independence of nominal variables with the real variables such as output and employment. According to classical theory, in a full employed economy, money is considered as a neutral factor and any increase in the money supply affects only the price level not real variables. The real variables in the economy are determined by real variables and no monetary variables have influence on them. And the nominal variables are determined by the monetary factors not the real variables.

The classical dichotomy relies on the assumptions of neutrality function of money and wage-price flexibility of classical theory. When there is an exogenous increase in the money supply, the price level also increases at the same rate. This makes goods costlier for workers thus they demand for rise in wages. As a result wages are increased at the same rate of the price increase. The effects of money supply ends here because the prices and wages are completely flexible in the classical model, money remains as a neutral factor which is incapable of influencing the real variables.  There are neither new jobs nor increased output and the system always remains at the static equilibrium. Any change in money supply is followed by an equal proportionate change in price level which restricts the system from any further alterations to output and employment.