Question

Suppose that a new Federal Reserve administration inspires greater public confidence in a stable inflation rate, and citizens begin to expect lower prices five years in the future. As a result, prices and nominal wages fall in the present and remain low, while GDP and real wages fall for a few months but then return to normal. True or false: this economy is well described by classical economics.

Answer 1

True, this type of economy is well described by classical economics

Step-by-step explanation:

The economy described has a stable low inflation.

This low inflation is expected to continue in the future, therefore, expected inflation is low too.

According to the Fisher effect, a low expected inflation rate will lower the nominal interest rate.

If the nominal interest rate pays little, then, investment will become less profitable, and fall.

A fall in investment induces GDP to grow less, and less GDP growth means less real wage growth because real wages depend on productivity.

However, GDP and real wages can adjust to these new conditions by reducing supply to meet the new demand, and find equilibrium again.

The economy described is probably deflationary, and a typical example is the Japanese economy in the 1990s.