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The setting of Irving's story is the Dutch settlement of Tarry Town, New York and takes place in 1790. Sleepy Hollow was a seculded little area of the town itself.
The setting of Sleepy Hollow, New York, is significant because one of the story's major themes is the conflict between "country" people and "city" people. The original settlers of the Tarry Town area were Dutch, and they are depicted as strong, hearty farm people. Abraham "Brom Bones" Brunt and the Van Tassels are examples of these people. On the other hand, Ichabod Crane is an outsider from Connecticut. He is a Yankee--an city man with English ancestry.
Sleepy Hollow is a secluded and very small glen off of the Tarry Town settlement area. This also helps set the mood for the spooky and comic events of the ending. If it were a city, or even a larger town, Brom Bones's Headless Horseman trick would not have worked against Ichabod Crane. Also, at the Van Tassels's party earlier, Brom Bones and the other Dutch farmers told old ghost stories from the area in order to lay the groundwork to scare Ichabod Crane. This worked because Crane is an outsider, whereas the Dutch farmers are the original settlers of Sleepy Hollow. Brom Bones knows the land and the history behind it, but Crane does not. In the end, when Brom Bones disguises himself as the Headless Horseman of legend (said to be the ghost of a Hessian trooper from the Revolutionary War), he chases Ichabod Crane all the way to the Old Dutch Burying Ground, a church and cemetery yard in Sleepy Hollow. In this Dutch colonial setting, the "country" man essentially wins over the "city" man.
It's clear that Washington Irving thought of the place where his story takes place as very significant. After all, the name of the town is in the title--"The Legend of Sleepy Hollow." Even more evidence is that fact that Irving begins the story with a lengthy and vivid description of the town and its surroundings. It is a sequestered area with an aura of magic and dreaminess. Sleepy Hollow lies in a little valley two miles away from the small market port of Tarry Town, and it is "one of the quietest places in the world."
The other consideration of the setting of Washington Irving's "The Legend of Sleepy Hollow" is the time period in which the story took place. Although Irving published his story in 1820, it takes place around 1790, 30 years earlier. The American Revolutionary War ended in 1783, so the story takes place in the years very soon right after the war. This was intentional, because the Revolutionary War is an important aspect of the narrative. The Headless Horseman himself is said to have been a soldier (a hired German trooper by the British army) in the war. Furthermore, Ichabod Crane's status as a Yankee, a "American" on the side of the colonies, is very prominent.
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