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

The correct option is (c).

Step-by-step solution

The explanation for (c)

The workers’ expectation regarding inflation is to be considered because the firms set the nominal wages according to the workers’ demand. So it is the worker’s expectation regarding inflation that matters. In this case, the firms expect inflation to rise by 6 percent while the workers expect inflation to rise by 9 percent. Thus, the workers would bargain to raise their nominal wages by 9 percent.

Therefore, as nominal wages and inflation would rise by the same percentage, the workers' real purchasing power would remain the same. Hence, to keep the real purchasing power unchanged, the nominal wages must rise by 9 percent when the inflation rate is expected to rise by 9 percent. So, the correct option is c.

The explanation for (a), (b), and (d)

Option a) is incorrect because if the worker's pay or nominal wages rises by 3 percent when the inflation rate is expected to rise by 9 percent, then the real purchasing power would fall. The reason is that the rise in the inflation rate is higher than the rise in nominal wages, implying a fall in real wages. So worker's pay must rise by 9 percent instead of 3 percent to keep real wages unchanged.

Option b) is incorrect because if the worker's pay or nominal wages rise by 6 percent when the inflation rate is 9 percent, the real purchasing power will fall. The reason is that the rise in inflation rate will be higher than the rise in nominal wages, which implies a fall in real wages. So worker's pay must rise by 9 percent instead of 6 percent.

Option d) is incorrect because if the worker's pay or nominal wages rise by 12 percent when the inflation rate is 9 percent, the real purchasing power will rise. The reason is that the rise in inflation rate will be lower than the rise in nominal wages, so the real purchasing power would not remain unchanged but rather rise. So worker's pay must rise by 9 percent instead of 12 percent.