Question

During a period of deflation, which is likely to increase faster: nominal average hourly earnings or real average hourly earnings? Briefly explain.

Short answer

During a period of deflation, real average hourly earnings are likely to increase faster than nominal average hourly earnings due to the increased purchasing power of money.

Step-by-step solution

Understand the terms Nominal and Real

Nominal income refers to the amount of money received in a given time period, without considering the effects of inflation or deflation. On the other hand, real income is the nominal income adjusted for inflation or deflation. It represents the purchasing power of the income.

Understand the effect of deflation

Deflation is a decline in general price levels. When deflation occurs, the value of money increases. Consequently, a given amount of nominal income can buy more goods and services than before.

Determine the effect of deflation on Real and Nominal Earnings

In a deflationary period, although the nominal income might remain unchanged, the real income will increase as the purchasing power of money increases. If the nominal average hourly earnings were to remain constant, the real average hourly earnings would increase at a faster rate due to increased purchasing power.

Key concepts

Nominal Income vs Real Income

To grasp the difference between nominal and real income, envision two layers of money. The first layer is the nominal income, which is the straightforward amount of money someone receives over a period of time. It's like the raw number on your paycheck before considering what that money can actually buy.

The second layer is real income, which digs deeper by adjusting nominal income for inflation or deflation. It provides a more accurate depiction of the money's true worth by reflecting purchasing power. In essence, if your nominal income stays the same but prices around you drop, your real income effectively increases.

Understanding the difference between these two forms of income is crucial, especially during periods of economic shifts like inflation or deflation. Knowing how much your income can actually buy is often more telling than just looking at the numbers themselves.

Purchasing Power

Purchasing power is a pivotal concept when discussing deflation, and it refers to the amount of goods or services that can be purchased with a unit of currency. It's important because it tells you how much your income is really worth.

Here's how it works: if prices for goods and services decrease in an economy, the same amount of money can buy more than before. That's an increase in purchasing power. During deflation, even if your nominal earnings stay unchanged, your ability to buy more stuff with the same amount of money improves.

Think of it like this:

• If a basket of groceries costs $50 and then prices drop so that the same basket costs $40, with the same income, you can purchase more.
• This makes the money you have more valuable in practical terms.

In summary, purchasing power rises during deflation, contributing to an improvement in real income without a change in nominal earnings.

Effects of Deflation

Deflation is characterized by a decline in the general price levels across the economy. While this may sound like a good thing for consumers, it has broader implications.

One of the primary effects is that the value of money increases. People see their purchasing power rise as goods and services become cheaper. However, deflation can also mean trouble for the broader economy:

• Consumer Spending: With falling prices, consumers might delay purchases, anticipating even lower prices in the future. This can slow economic growth.
• Debt Burden: The real value of debt increases. Consequently, individuals and businesses find it harder to pay their debts as the income they receive is worth more, but they owe the same amount.
• Impact on Earnings: While nominal average hourly earnings might stagnate, real earnings improve because of increased purchasing power.

Deflation, therefore, creates a paradox where individual purchasing power might improve, but the broader economy could struggle due to decreased spending and increased debt burdens. It's crucial to consider both the short-term benefits and long-term consequences when analyzing deflation's effects.