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 2%. Inflation is expected to be 3%, so they agree on a 5% nominal wage increase.

Now, suppose inflation turns out to be lower than expected, coming in at 2%. This would (benefit or harm) the union and (benefit, harm) Friendly Airlines because the real wage increase would now be?

Answer and Explanation:

As we know that

Nominal interest rate = Real interest rate + inflation rate

where

Nominal interest rate is 5%

Real interest rate is 2%

So, the inflation rate is 3%

Now if the inflation rate is increased by 2%

So the new inflation rate is 4%

And, the nominal interest rate would remain the same i. e 5%

So, the real interest rate is

= 5% - 4%

= 1%

Since the interest rate declines that decreased the consumer purchasing power

Moreover, the increase in the inflation rate declines the workers real wages i. e purchasing power also falls

So if there is an increase in inflation than it would be harmful for the union and benefit Friendly Airlines as the real wage increased would be less or low