Question

Suppose you're a union worker. Your union negotiates an annual 3% increase in salary for you and your fellow union members for the next three years. The expected annual inflation rate is 2%.

1. What is your real expected change in salary?

2. Suppose expectations aren't met, and rather than the price inflation increasing by 2% prices, price decrease by 2% annually for the next three years. Assuming you remain employed are you helped or hurt by this change? What is your real change in salary now? Is your employer pleased or unhappy about this outcome?

Answer 1

Union negotiates an annual 3% increase in salary;

The expected annual inflation rate is 2%.

1.

Expected Real increase in salary = Nominal increase - inflation rate

so, real increase in salary = 3% - 2% = 1%

..

2. Suppose expectations aren't met, and rather than the price inflation increasing by 2% prices, price decrease by 2% annually for the next three years.

Therefore the real interest rate = 3% - (-2%) = 3% + 2% = 5%

Due to fall in prices we are benefited as our real increase in salary is now 5% which was previously 1%.

our employer is unhappy about this outcome as even the prices are falling he is paying more to his workers