Economics Classical and Keynesian

Topics: Inflation, Economics, Macroeconomics Pages: 6 (1964 words) Published: October 4, 2013
1. Suppose during 2012 there is a sudden unanticipated burst of inflation. Consider the situations faced by the following individuals—who gains and who loses? a. A homeowner whose wages will keep pace with inflation during the year, but whose monthly mortgage payments will remain fixed. This person has gained. Nominal income is income that you receive in a given time period and it is measured in current dollars. Real income is nominal income adjusted for inflation and is the purchasing power that your money has. Real income dictates the amount of goods and services the nominal income will buy. The homeowner’s nominal income has increased (say 3%), but inflation has increased by the same amount (3%). The 3 percent increase in inflation reduces the 3 percent increase in nominal income, so the nominal income has not increased faster than inflation. The nominal income has kept pace with inflation. The homeowner’s gain is in regards to his fixed mortgage. Because his mortgage is fixed, it is immune to the inflation increase. If his nominal income in 2011 is $30,000 and his mortgage is $12,000 per year, he has $18,000 remaining to pay all other expenses in 2011. If the homeowner receives a 3 percent raise, his nominal income for 2012 will be $30,900.00. His mortgage payment is fixed and will remain $12,000.00 per year. This leaves $18,900.00 of nominal income. When you reduce this nominal income by 3 percent to adjust for inflation, the homeowner has $18,333.00 of real income to pay for all other expenses in 2012. This is an increase of $333.00 from the year 2011 to 2012. This is not a huge increase, but this homeowner does gain. He can purchase more goods and services in 2012 than he did in 2011. 2011 Budget

2012 Budget

Nominal income for 2011
$30,000.00
Nominal income for 2012 with 3% raise from 2011
$30,900.00
Mortgage in 2011
$12,000.00
Mortgage in 2012
$12,000.00
Money remaining for other expenses
$18,000.00
Money remaining for all other expenses for the year 2012 before adjusted for inflation $18,900.00

Subtracting 3% from $18,900.00 to adjust for inflation, the real income per year is $18,333. This is the money remaining for all other expenses in 2012: $333 more than in 2011. $18,333.00

b. An apartment landlord who has guaranteed to his tenants that their monthly rent payments will remain the same as it was in 2011. The landlord loses because he receives less real income when inflation increases unexpectedly. The rent from his tenants becomes less than if prices had remained stable. The landlord’s income comes from the rent payments of the people living in the building. If he collects $200,000 in 2011 from rent payments, his nominal income for 2011 is $200,000. If inflation is 3 percent in 2012, his real income decreases. Real income is nominal income adjusted for inflation. Three percent inflation would reduce the nominal income by $6,000. This person’s real income would be $194,000. This is obviously less purchasing power than he had in 2011. Because the landlord’s nominal income stays the same and prices increase, his real income falls and his money has less purchasing power. He can buy fewer goods and services in 2012 than he did in 2011. The landlord’s nominal income has not risen faster than the rate of inflation and he ends up with a smaller share of total output. Inflation causes a redistribution of income and wealth. The landlord’s income has been redistributed. Inflation has caused $6,000 of the landlords’ money to be redistributed to the tenants. The tenants will continue to purchase at least as many goods and services in 2012 as they did in 2011. The landlord’s real income will fall relative to people whose nominal income increases with inflation. This income redistribution acts like a tax. It takes income or wealth from one group and gives it to another. Those who have gained in this situation are the tenants whose rent will not increase, but the landlord loses. c. A retired...
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