Suppose expected inflation in the economy is 5%. Banks set nominal interest rates so they'll earn a 2% expected real return. Employers set nominal wages based on a 2% expected real wage increase. Suppose the nominal interest rate and nominal wages are determined this way, but actual inflation turns out to differ from the expected inflation rate. Calculate the actual real interest rate and the percent increase in the real wage for each of the following actual inflation rates: a) 2%; b) 5%; c) 10%.
What will be an ideal response?
The real interest rate (r) = the nominal interest rate minus the inflation rate. In percentage terms, the percentage increase in the real wage (w) = the percentage increase in the nominal wage minus the inflation rate. It is given that the expected inflation rate = 5%, so the nominal interest rate on bank savings deposits = 7%, and the percentage increase in the nominal wage = 7%. When inflation is
| (a) | When inflation is 2%, then r = 7% - 2% = 5%, and the percentage increase in w equals 7% - 2% |
| (b) | When inflation is 5%, then r = 7% - 5% = 2%, and the percentage increase in w equals 7% - 5% |
| (c) | When inflation is 10%, then r = 7% - 10% = -3%, and the percentage increase in w equals 7% - |
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