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? \(L O 38.4\) 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

Understanding the Problem

Workers want to maintain their purchasing power despite inflation, meaning the real value of their wages should stay the same. If inflation is expected at 9%, they need a pay raise equal to that percentage to keep up with rising prices.

Inflation Expectation Analysis

Since workers expect prices to rise by 9%, they will require a 9% increase in their wages. This pay raise should compensate for the anticipated increase in the cost of living.

Conclusion Based on Inflation Expectation

Because the goal is to match the expected inflation with the pay raise to maintain purchasing power, the workers demand a pay raise that equals the expected inflation rate of 9%.

Key concepts

Purchasing Power

Purchasing power is all about what you can actually buy with the money you earn. It directly relates to the value of currency in your pocket. If prices rise due to inflation but your income stays the same, you can afford to buy less. This means your purchasing power has decreased. To maintain purchasing power, wages need to increase at the same rate as prices increase. That way, you will still be able to purchase the same amount of goods or services. Think about shopping at the grocery store: if a basket of groceries costs $100 one year and increases to $109 the next, earning the same $100 means buying less. Increasing your income to $109 keeps your purchasing power steady.

• Inflation directly impacts purchasing power.
• Maintaining purchasing power ensures wages rise with inflation.
• Purchasing power is crucial for maintaining a stable standard of living.

Wage Expectations

Wage expectations reflect what employees anticipate or desire to earn in the future. This expectation is often based on factors such as inflation predictions, personal needs, and job market trends. In the context of inflation, workers expect their wages to increase enough to counteract the anticipated rise in prices. This is essential to maintain their purchasing power. If workers expect 9% inflation, as in the exercise, they will demand a raise of 9% to ensure their income's value doesn't diminish.

• Wage expectations are often aligned with inflation rates.
• They help employees plan their personal finances.
• Understanding market trends can shape realistic wage expectations.

Cost of Living

The cost of living refers to the amount of money needed to cover basic expenses like housing, food, taxes, and healthcare. It varies by location and is affected by inflation. When prices rise, the cost of living goes up, meaning people need more money to maintain the same lifestyle. For instance, if the cost of living increases by 9% due to inflation, and wages do not increase, it impacts what people can afford. Salary adjustments that match the cost of living increase are crucial to maintaining a consistent quality of life.

• Inflation increases the cost of living.
• Wage increases should match cost of living changes to maintain lifestyle.
• Regional differences affect the cost of living, influencing wage demands.

Real Wages

Real wages represent the purchasing power of income after adjusting for inflation. They offer a clearer picture of an individual's economic well-being compared to nominal wages, which are just the wages received without considering price changes. In the given exercise, if the workers' nominal wages are increased by 9% to match the inflation rate, their real wages remain constant, keeping their purchasing power steady. Real wages are crucial for understanding the true benefits of pay raises. For example, an increase in pay might sound great, but if prices rise at the same rate, your real wage—and thus your ability to buy things—stays the same.

• Real wages take inflation into account for a clearer financial picture.
• A salary raise that matches inflation keeps real wages steady.
• Assessing real wages helps workers understand true income changes.