Question

In: Economics

4. Suppose that people expect inflation to equal 3 percent, but in fact, prices rise by...

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.

    1. a homeowner with a fixed-rate mortgage.
    2. a union worker with a fixed labour contract
    3. a company that has invested some of its endowment in government bonds which pays a fixed rate of return.

5. Indicate how each of the following events would affect the aggregate demand AD curve:

    1. a short-run decrease in the price level
    2. an increase in consumer confidence on the price level and real GDP
    3. an increase in government purchases

Solutions

Expert Solution

4) Given that people expect rate of inflation as 3 % but the price increases by 5%. Lets have a look at how this might impact on the following

  • a homeowner with a fixed-rate mortgage will have a positive impact. This means that it helps these groups as inflation as 3% and price increases to 5%. This is because the interest rate depends only on inflation.
  • a union worker with a fixed labour contract gets hurt because the worker will receive lesser real wage due to inflation.
  • a company that has invested some of its endowment in government bonds which pays a fixed rate of return gets hurt. This is because the increase in inflation causes a lesser interest rate to be gained.

5) Lets see how the following events would affect the aggregate demand AD curve

  • A short-run decrease in the price level will impact downward movement along the AD curve since price level and quantity are inversely proportional. that means AD is downward slopping.
  • An increase in consumer confidence on the price level and real GDP, spending will increase. Hence the AD will increase and this shows a right shift in AD curve.
  • an increase in government purchases motivates employment rate to increase hence income rises. Then the AD shifts right as AD increases.

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