Economics Classical and Keynesian
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
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