Final answer:
The classical dichotomy refers to neoclassical economics' notion that nominal variables do not affect real variables in the long run, with the economy adjusting back to potential GDP and natural unemployment levels once wages and prices become flexible.
Option 'b' is the correct.
Step-by-step explanation:
Understanding the Classical Dichotomy
The concept you're asking about is known as the classical dichotomy, which is a fundamental principle in neoclassical economics. In essence, the classical dichotomy posits that in the long run, nominal variables do not affect real variables.
To clarify, nominal variables are those measured in monetary units (like the money supply or price level), whereas real variables are those measured in physical units (such as real GDP, employment, or physical capital). The classical dichotomy suggests that there is a clear separation between the two, with nominal variables influencing only prices and other nominal variables, and real variables determining the economy's production and employment.
In the short run, economic fluctuations can lead to changes in employment and output due to sticky wages and prices. However, according to neoclassical thought, in the long run, the economy will adjust to shifts in aggregate demand so that output returns to its potential GDP, and the temporary effects on unemployment disappear as the labor market adjusts. This is because, in the long run, wages and prices are flexible, allowing the economy to return to equilibrium at its potential output with natural levels of unemployment.
The neoclassical view contrasts with Keynesian economics, which suggests that due to wage and price rigidity, adjustments can take a very long time, and therefore, monetary and fiscal policy can have significant impacts on real variables like output and unemployment in the short run. Hence, understanding the speed of macroeconomic adjustment is crucial to applying the appropriate economic theory and policy.