Classical Dichotomy The classical dichotomy is rooted in the understanding that in the long run, real output is determined by “real” inputs such as labour, capital, natural resources and TFP, but not money. This means that changes in the money supply determine changes in the price level over time, but not real output. However, it is important to remember that the classical dichotomy applies only in the long run. Almost all economists would agree that money and price can have very important real impacts on the economy in the shorter run. In macroeconomics, the classical dichotomy refers to an idea attributed to classical and pre-Keynesian economics that real and nominal variables can be analyzed separately. To be precise, an economy exhibits the classical dichotomy if real variables such as output and real interest rates can be completely analyzed without considering what is happening to their nominal counterparts, the money value of output and the interest rate. In particular, this means that real GDP and other real variables can be determined without knowing the level of the nominal money supply or the rate of inflation. An economy exhibits the classical dichotomy if money is neutral, affecting only the price level, not real variables If an economy exhibits the classical dichotomy, then comparative statics analysis can be performed using a Jacobian matrix in block triangular form. That is, suppose we write
where represents some exogenous shocks (changes in productivity, aggregate demand, money supply, etc., ordered so that all real shocks come first), and represents the change in the endogenous variables (output, employment, prices, etc., again listing real variables first). Then the matrix J can be partitioned into submatrices as follows:
In other words, when the classical dichotomy holds, it is possible to calculate how all the real variables change by inverting the submatrix only, thus excluding all nominal variables like money supply and prices from the analysis. Underemployment Equilibrium
Definition of 'Underemployment Equilibrium'
A condition where underemployment in an economy is persistently above the norm and has entered an equilibrium state. This, in turn, is a result of the unemployment rate being consistently above the natural rate of unemployment or non-accelerating inflation rate of unemployment
Investopedia explains 'Underemployment Equilibrium'
Underemployment in an economy implies that workers have to settle for jobs that require less skill than they possess, or that offer lower wages or fewer hours than they would like. The degree of underemployment is dictated by the strength (or lack thereof) of the job market, and tends to rise when the economy and employment are weak. Advocates of Keynesian economics suggest that a solution to an underemployment equilibrium state is through deficit spending and monetary policy to stimulate the economy. Keynes effect
The Keynes effect is the effect that changes in the price level have upon goods market spending via changes in interest rates. As prices fall, a given nominal money supply will be associated with a larger real money supply, causing interest rates to fall and in turn causing investment spending on physical capital to increase.  This implies that insufficient demand in the product market cannot exist forever, because insufficient demand will cause a lower price level, resulting in increased demand. There are two cases in which the Keynes effect does not occur: in the liquidity trap (when the LM curve is horizontal and thus changes in the real money supply do not affect interest rates), and when expenditure is inelastic with respect to (unresponsive to) interest rates (when the IS curve is vertical). The Patinkin-Pigou real balance effect suggests that due to wealth effects of changes in the price level upon spending itself, insufficient demand cannot persist even in the two cases in which the Keynes effect does not...
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