Question

Suppose that firms are expecting 6 percent inflation while workers are expecting 9 percent inflation. How much of a pay raise will workers demand if their goal is to maintain the purchasing power of their incomes? a. 3 percent. b. 6 percent. c. 9 percent. d. 12 percent.

Short answer

Workers will demand a 9% pay raise.

Step-by-step solution

Understand the Problem

The goal is to determine how much of a pay raise workers would need to maintain their purchasing power, given their inflation expectation of 9 percent.

Define Maintaining Purchasing Power

Maintaining purchasing power means that the workers want their real income to stay constant. If inflation is 9%, their purchasing power reduces unless their income increases by the same rate.

Calculate the Required Pay Raise

Since workers expect a 9% inflation and want to maintain purchasing power, they demand a raise equal to their expected inflation rate. So, they will demand a 9% pay raise.

Key concepts

Expected Inflation

Expected inflation plays a crucial role in financial planning. It refers to the rate at which individuals, firms, or economic analysts anticipate prices will increase over a given period. These expectations can influence a variety of economic decisions.

• Consumers who expect higher inflation might decide to spend more now, to avoid paying higher prices later.
• Firms might adjust their pricing strategies and wage offerings based on anticipated inflation.
• Governments and central banks use expected inflation to form monetary policy, aiming to stabilize the economy.

For workers, understanding expected inflation is essential as it helps preserve the value of their paychecks. If they anticipate that everything will cost 9% more next year, they would logically seek at least a 9% salary increase. This ensures that their income retains its purchasing power, allowing them to buy the same goods and services, despite rising prices.

Real Income

Real income is a measure of purchasing power; it reflects the amount of goods or services that an individual can purchase with their income, adjusted for inflation. It is calculated by taking nominal income (the amount of money earned) and adjusting it for changes in price levels.

• If nominal income increases by 6% but inflation is 9%, real income actually decreases.
• A decrease in real income means workers can afford to buy less, even if they earn more money.
• Conversely, if inflation is lower than the income increase, real income would effectively go up.

In an economy with expected inflation, workers aim to adjust their nominal wages to keep their real income stable. By doing so, they can maintain their lifestyle without experiencing a drop in purchasing power.

Maintaining Purchasing Power

To maintain purchasing power in the face of expected inflation, workers must obtain salary adjustments that equal the rate of inflation. This is because inflation erodes the value of money.

• For example, if a loaf of bread costs $2 today and inflation is 5%, the price will be $2.10 next year. Workers would need their income to rise by at least 5% to buy the same amount of goods.
• This principle extends beyond individual products to an entire economy's basket of goods and services.
• If wages don't keep up with inflation, workers find themselves with reduced buying capacity.

In the given exercise, if workers expect a 9% inflation, they must demand a 9% pay raise to prevent a loss of purchasing power. This helps them maintain their standard of living as prices increase.