Suppose that people expect inflation to be 3 percent but that, in fact, prices rise by 5 percent. Describe how this unexpectedly high inflation would help or hurt the following: a. the government b. a homeowner with a fixed-rate mortgage c. a union worker in the second year of a labor contract d. a college that has invested some of its endowment in government bonds

When inflation takes an unexpected turn upwards, it can have significant implications for government debt. For instance, imagine a scenario where inflation was predicted to be 3%, but it actually rose to 5%. In such a case, the government finds itself in a peculiarly advantageous position. This is because the real value—the purchasing power—of government debt diminishes with higher inflation. That’s practically like getting a discount on the debt they owe.

Government obligations, like bonds, are often issued with fixed interest rates. If these rates do not adjust for inflation's surge, the government ends up paying back debt with 'cheaper dollars.' In essence, as the general price level increases, each dollar is worth less, so paying back debt requires less value than when the debt was incurred. It's like borrowing a fancy sports car, and returning a less-valuable model years later—it still serves the same function, but its value isn't what it once was.

However, this isn't an unmitigated boon. While reducing the real debt burden, higher inflation could increase the cost of borrowing in the future, as lenders may demand higher interest rates to compensate for the anticipated decrease in purchasing power. The government's balancing act between inflation and debt management is like walking a tightrope—requiring precision, foresight, and a dose of good luck.

Let's consider the world of fixed-rate mortgages when inflation jumps unexpectedly. A homeowner with such a mortgage has agreed to repay their loan at a set rate. If inflation was expected to be 3% but jumps to 5%, this homeowner has cause for a quiet celebration.

Here's why: payments on their mortgage remain constant in nominal terms, but with inflation higher than anticipated, these payments are effectively smaller in real terms. It's like agreeing to pay back a loan with apples when apples were rare, and suddenly, there's an abundance of apples. The burden of the debt decreases because the currency used to pay the mortgage—the 'apples'—is less valuable.

Not only does the homeowner benefit by paying back less in real terms, but they may also see an increase in the nominal value of their property due to inflation. Nevertheless, it’s not all roses—a continual surge in inflation could also bring about increased costs of living, potentially offsetting the benefits of the diminished real mortgage payments.

Inflation's twist on union workers under a fixed labor contract can be quite the conundrum. Consider a union worker in the second year of their labor contract, with a preset wage increase premised on a 3% inflation expectation. Now, if actual inflation surges to 5%, the worker's wage increase suddenly doesn't stretch as far as it was supposed to.

Everyday items and services become more expensive, but the increase in salary doesn’t match this change, so it’s almost as if the worker has received a cut in pay when inflation's bite is felt. It illustrates why many labor contracts include clauses for cost-of-living adjustments, which act as a safeguard against this very scenario. Without such protective measures, workers can find themselves pinched in their wallets, struggling to keep up with the rising cost of living despite being in what seemed like a stable wage agreement.

Colleges, among other investors, often rely on government bonds for a stable source of income from their endowments. When inflation jumps unexpectedly—from 3% to 5%, as per the scenario—this stability is rocked. Bonds typically pay a fixed rate of return, and if they are not indexed to accommodate inflation's fluctuations, investors face a diminishing real yield.

Let's break it down with an example. A college's endowment invested in government bonds is expecting a certain purchasing power from the returns. With inflation on the rise, however, the actual goods and services that can be secured with those returns are less than expected—it's a scenario akin to planning a meal based on expected prices, only to find that everything at the grocery store is now 20% more expensive. This situation could compromise the college's financial planning and its ability to fund scholarships, research, and facilities maintenance.

In response, some institutions may seek to diversify their investments to mitigate the risk of such inflationary surprises. Building a mixed portfolio with assets that may benefit from inflation, such as real estate or commodities, could provide a counterbalance to the potential losses in bond purchasing power.