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Chapter 28: Problem 10

A 2017 column in the Wall Street Journal noted that "longterm consumer inflation expectations [are] at record lows." If inflation turns out to be higher than households and firms had previously expected, will the actual real wage end up being higher or lower than the expected real wage? Will employment in the short run end up being higher or lower? Briefly explain.

Short Answer

Expert verified
When inflation is higher than expected, the actual real wage comes out to be lower than the expected real wage due to a larger than anticipated decrease in the purchasing power of wages. However, in the short run, employment is likely to be higher as labor costs for employers reduce leading to more hiring.

Step by step solution

01

Understand Inflation Impact on Wages

Inflation erodes the purchasing power of money. This means that if inflation is higher than expected, the purchasing power of the wage decreases more than anticipated. Consequently, the real wage (which accounts for inflation) is lower than the expected real wage. The expected real wage is the wage that workers thought they would receive adjusted for the level of inflation they anticipated.
02

Analyze Employment Impact

Now, with the real wage being lower than expected due to higher than forecasted inflation, employers find labor (or hiring workers) relatively cheaper. Consequently, ceteris paribus (other factors remaining constant), they will hire more workers in the short run, thus employment will be higher.
03

Summary of the Results

When inflation turns out to be higher than expected, it reduces the purchasing power of wages more than anticipated. Therefore, the actual real wage is lower than the expected real wage. On the employment front, this unexpected inflation makes the labor cheaper for employers, leading to increased hiring in the short run, hence higher employment.

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Most popular questions from this chapter

What was the "Volcker disinflation"? What happened to the unemployment rate during the period of the Volcker disinflation?

Why did Milton Friedman argue that the Phillips curve did not represent a permanent trade-off between unemployment and inflation? In your answer, be sure to explain what Friedman meant by the "natural rate of unemployment."

Why do workers, firms, banks, and investors in financial markets care about the future rate of inflation? How do they form their expectations of future inflation? Do current conditions in the economy have any effect on how they form their expectations? Briefly explain.

While many economists and policymakers supported the Fed's decision to maintain the federal funds rate at a nearzero level for over six years, Charles Schwab, the founder and chairman of a discount brokerage firm that bears his name, argued that the economy was harmed by keeping interest rates low for an extended period of time: U.S. households lost billions in interest income during the Fed's near-zero interest rate experiment.... Because they are often reliant on income from savings, seniors were hit the hardest.... Seniors make up \(13 \%\) of the U.S. population and spend about \(\$ 1.2\) trillion annually.... This makes for a potent multiplier effect. a. What type of spending was Schwab expecting would have increased if the Fed had raised interest rates earlier than it did? b. Would higher interest rates have had an effect on other types of spending? Briefly explain. c. Which of the types of spending that you discussed in answering parts (a) and (b) does the Fed appear to believe has the more "potent multiplier effect"? Briefly explain.

The text discussed how if General Motors and the UAW fail to accurately forecast the inflation rate, the real wage will be different than the company and the union expected. Why, then, do the company and the union sign long-term contracts rather than negotiate a new contract each year?
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