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

Your union negotiates 3% increase in salary;

Expected annual inflation rate = 2%.

1.

Expected Real increase in salary = Nominal increase - inflation rate
So, increase = 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.

So, real interest rate = 3% - (-2%) = 5%

Thanks to the decline in prices, we are gained because our actual wage rise is now 5 per cent, which was previously 1 per cent.

Our employer is dissatisfied with this outcome, because even the prices are dropping, still he pays more to his employees.

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