Question

1. (10 points total) Your best friend in Europe is bragging that he just received a 10% annual raise. However, you just learned in your economics class that inflation in his country has jumped a full 20% this year. a) How impressed are you with your friend's real raise? b) What is truly his real percentage raise? Explain with words as well as with arithmetic. (The index for deflation is 120 and assume income went from $100 to $110.) C. up od lo sono nos last edge ( YoT) tops loodit (aniogaa

Answer 1

1 a) We are not at all impressed by the friend’s real raise.This is because the rate of inflation is higher than the rate of annual raise. This means that although the salary has increased in monetary terms, but in actual the purchasing power of his friend has actually decreased, which makes him worse off , because the increase in price of the goods is higher than the increase in the salary.

b) His truly percentage real raise in his salary is (1.1/1.2) - 1 = -0.0833.

This means that in actual, the friend has been worse off because his salary has decreased in real terms by 8.3333%.This means that the purchasing power of the friend has decreased by 8.333%. This shows that the friend’s salary has increased only in monetary terms, whereas the purchasing power has actually reduced.

Suppose that the initial income was $100 and the price of the good is $10. Now after increasing the income by 10%, the new income will be $110. After increasing the price by 20% , the new price is $12.

Initially, the friend could purchase (100/10)= 10 units , whereas now the friend can only purchase (110/12) = 9.167 units of that good. This shows that there has been a 8.333% drop in the purchasing power of the friend.

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