Question

Suppose Friendly Airlines is considering signing a long-term contract with the union representing its pilots. Friendly Airlines and the union both agree that real wages should increase by 3%. Inflation is expected to be 6%, so they agree on a 9% nominal wage increase.

Now, suppose inflation turns out to be higher than expected, coming in at 7%. This would harm the union and benefit Friendly Airlines because the real wage increase would now be ________. Because of uncertainty about future inflation, the union devotes a large quantity of resources to monitoring inflation indicators in order to maximize its financial position. This illustrates the fact that: Inflation harms lenders and helps borrowers Variable inflation is associated with high transaction costs Inflation obscures relative price changes

Answer 1

If inflation unexpectedly rises to 7%, the real wage increase for the union would be 2%, benefiting Friendly Airlines. A 5% unexpected rise in inflation hurts individuals with cash or fixed-rate loans, but a COLA wage contract would protect the individual from inflation's impact. Indexing contracts to inflation helps maintain purchasing power.

Step-by-step explanation:

When inflation rises unexpectedly to 7%, instead of the agreed 6%, the real wage increase for the union would be less than the agreed 3%, specifically 2% (9% nominal increase - 7% inflation). This scenario benefits Friendly Airlines as the actual compensation increase is lower than initially planned. The large resources devoted by the union to monitoring inflation reflect the high transaction costs associated with variable inflation.

Regarding the impact of a 5% unexpected rise in inflation on different economic actors:

• A union member with a COLA (Cost of Living Adjustment) wage contract is generally unaffected as their wage will automatically adjust to cover the increased cost of living due to inflation.
• Someone with a large stash of cash in a safe deposit box is hurt as the value of their cash depreciates.
• A bank lending money at a fixed rate of interest is also hurt because it gets repaid in devalued currency.
• A person who is not due to receive a pay raise for another 11 months is hurt since their purchasing power will decrease while waiting for the raise.

Meanwhile, indexing wage contracts and interest rates to inflation helps prevent the decrease in purchasing power and standard of living that can occur when wages fail to keep up with rising price levels.