Question

If inflation rises unexpectedly by \(5 \%,\) indicate for each of the following whether the economic actor is helped, hurt, or unaffected: a. A union member with a COLA wage contract b. Someone with a large stash of cash in a safe deposit box c. A bank lending money at a fixed rate of interest d. A person who is not due to receive a pay raise for another 11 months

Short answer

a. Helped b. Hurt c. Hurt d. Hurt

Step-by-step solution

a. Union member with a COLA wage contract

A COLA (Cost of Living Adjustment) wage contract ensures that wages are adjusted according to changes in the cost of living, which includes accounting for inflation. Since this union member has a COLA wage contract, their wage will be adjusted as inflation rises. Therefore, this union member is \(helped\) because they are protected from the negative effects of inflation.

b. Someone with a large stash of cash in a safe deposit box

With an unexpected rise in inflation, the purchasing power of cash decreases, because the same amount of cash will buy fewer goods and services. Therefore, someone with a large amount of cash in a safe deposit box will be \(hurt\) by the unexpected rise in inflation as the value of their cash effectively diminishes.

c. A bank lending money at a fixed rate of interest

When inflation rises unexpectedly, the value of money decreases; thus, the money a bank lends out at a fixed rate of interest will be worth less in the future when paid back by borrowers. This means that, in real terms, the bank will receive less money than it originally lent. As a result, the bank is \(hurt\) by the unexpected rise in inflation.

d. A person who is not due to receive a pay raise for another 11 months

An unexpected rise in inflation decreases the value of money, which means the purchasing power of an individual's wage would decrease. In this particular case, the person would continue to receive the same wages for another 11 months before a pay raise. Since the person won't receive adjustments to their wage sooner, they are \(hurt\) by the unexpected rise in inflation because their purchasing power decreases during this period..

Key concepts

Cost of Living Adjustment (COLA)

The concept of a Cost of Living Adjustment (COLA) is crucial for protecting workers' salaries from the erosive effects of inflation. A COLA is an annual adjustment to salaries to counteract the loss of purchasing power due to inflation.

For example, if inflation is at 5%, and a worker's salary is adjusted through a COLA, their new salary should be able to buy the same amount of goods and services post-inflation as it did before. Without a COLA, the worker would effectively be earning less than before due to the higher prices of goods and services.

Purchasing Power

Purchasing power refers to the quantity of goods and services that one unit of currency can buy. Inflation directly impacts purchasing power by reducing it; this means that every dollar, euro, or any other currency unit buys less than it did before inflation increased.

When we say someone is 'hurt' by inflation, we're often referring to a decline in their purchasing power. For instance, a person with cash savings will find that these savings will afford them fewer goods or services over time if they do not earn interest at a rate that outpaces inflation. This reduction in purchasing power is a silent yet stark impact of inflation on individuals' wealth.

Fixed-Rate Interest Loans

Fixed-rate interest loans lock in the borrowing cost for the life of the loan, meaning the interest rate remains constant regardless of changes in the wider economy. This can be beneficial for borrowers during periods of rising inflation, as they continue to repay their debt with money that is worth less over time, effectively reducing the real cost of their loan.

From the lender's perspective, however, this is a disadvantage because they receive payments in currency that has lower purchasing power than when the loan was given out. Banks and other lending institutions are 'hurt' under these conditions as the money repaid is worth less, highlighting the risks involved with fixed interest rates in a volatile economy.