Question

Suppose that people expect inflation to equal 3%, but in fact prices rise by 5%. Describe how this unexpected high inflation rate would help or hurt the following:

a. the government; (3%)

b. a homeowner with a fixed-rate mortgage; (3%)

c. a union worker in the second year of a labour contract; and (3%)

d. a college that has invested some of its endowment in government bonds. (3%)

Answer 1

a)

Since here inflation turns out to be more than expected. Following would impact on the government:

• An increase in inflation will increase the tax revenue of government. Now more people will slip into the tax bracket.
• Government debt liability will fall as now the purchasing power of money decline.
• Now the government has to make expenditure on social programs such as free education.

b)

Homeowner liabilities do not change or they are supposed to pay the only a fixed amount but since inflation has caused the fall in the value of money. Thus, these homeowners would be benefited from the unexpected rise in the inflation rate.

c)

Union workers would be harmed by the unexpected inflation. Since contract has been indexed to expected inflation and actual inflation turns out be different from the expected inflation. Thus real wage of workers declines,

d)

Investment in the fixed income bound would not be beneficial in the face of unexpected inflation. The real income from the investment in the bond will decline. Fixed income earners suffer the loss due to rise in the inflation which is unexpected.