Question

4. Suppose that people expect inflation to equal 3 percent, but in fact prices rise by 5 percent. Indicate whether this unexpected higher rate of inflation would help or hurt each of the following groups. a. a homeowner with a fixed-rate mortgage. b. a union worker with a fixed labor contract C. a company that has invested some of its endowment in government bond which pay fixed rate of return. 5 Indicato bow 0ach of +he following ovents

Answer 1

Expected inflation = 3%

Actual inflation = 5%

As the inflation is more than expected inflation, there would be fall in real buying capacity of dollars.

a) As homeowner gets fixed rent from tenant as per their contract whose real value becomes less after unanticipated inflation. Assume rent is $1,000 and basket of a goods cost $100 and it is expected to cost $103 and landlord have fixed their rent as per the expected inflation such that even after inflation of 3%, he can buy all the things from the rent he gets. If the basket cost $105, landlord will have to pay $2 extra while the rent is same, Thus, if he spends the same amount as before of $103, he will be able to buy less units (which means less real buying capacity of dollars), which makes landlord hurt.

b) A union worker would be hurt as he will get the same salary as before but will be able to buy less units if he spends the same amount on goods as before.

c) Company that have invested would be hurt as due to fall in real buying capacity of dollars, they will get less buying capacity of the the return they earn. Remember, lender or investor will always hurt from the unanticipated inflation while borrower benefits from it.