lears the labor market, the real wage and the level of employment can be figured out by using diagram two. Once given the level of employment determined from diagram two, it is possible to use diagram one to figure out the level of output. So diagrams one and two, also know as the real sector, can be used to determine employment, real output, and the real wage without any knowledge of the monetary sector of the classical model. The monetary sector, given the level of real output, determines only the monetary or nominal variables such as the price level and the money wage. The separate treatment of the monetary sector and real sector is known as the 'Classical dichotomy.' To complete the model, diagrams three, four, and five are needed. Diagram three represents the Classical aggregate demand curve, which shows the relationship between real aggregate demand for output, y, on the horizontal axis, and the price level P, on the vertical axis. Real aggregate demand represents the sum of the demands for output of all the individuals in the economy. The Classical aggregate demand curve, AD, illustrates the level of aggregate demand for a given price level. Since the government or the central bank can control the quantity of money in circulation, it also controls the position of the Classical aggregate demand curve. But it can only control the price level and other nominal variables because it is independent of the monetary sector. The full understanding of the classical model comes with diagrams four and five, which consider money-wage determination and interest rate determination respectively. In diagram four, the real wage, w, is defined as the money wage, W, divided by the price level, P. For this reason there is a relationship between money wages and the price level which results in a straight line through the origin that corresponds to the real wage. The higher the price level, the higher the money wage must be to maintain any given real w...
