Question

Suppose that firms were expecting inflation to be 3 percent, but it actually turned out to be 7 percent. Other things equal, firm profits will be:

a. smaller than expected

b. larger than expected

Short answer

The correct option is (b).

Step-by-step solution

The explanation for correct option (b)

The changes in the inflation rate affect the profit level of the firms. According to the question, the expected inflation rate was 3 percent. So the workers would set the nominal wages based on a 3 percent inflation rate. Now, if the actual inflation rate rises by 7 percent while nominal wages are rigid, it would lead to a rise in the firm’s profit level. In response to higher profits, the firms would hire more workers and produce more output.

Thus price and output level are positively related in the short run. It indicates that the firm’s profit would rise in response to a rise in the actual inflation rate. So option b) is correct.

The explanation for incorrect option (a)

Option a) is incorrect because the firms generally fix the input price (nominal wages) based on the expected inflation rate. So if the actual inflation rate is higher than the expected inflation rate, then the output price rises while the cost of production remains the same. So the firms would receive higher profits and not lower. Hence option a) is incorrect.