Question

Caroline's paycheck each week is $12 per hour times the number of hours she works. Caroline thus currently earns a ___ wage of $12 per hour. Suppose the price of sparkling water is $3 per gallon. The amount of sparkling water she can buy with her paycheck is ___ of sparkling water, which represents her ___ wage.
When workers and firms negotiate compensation packages, they have expectations about the price level (and changes in the price level) and agree on a ___ weage with those expectations in mind. If the price level turns out to be higher than expected, a worker's ___ wage is ___ than both the worker and employer expected when they agreed to the wage.

Suppose that Caroline and her employer both expected inflation to be 3% between 2011 and 2012. They signed a two-year contract stipulating that Caroline would earn $12 per hour in 2011 and $12.36 per hour in 2012. However, actual inflation between 2011 and 2012 turned out to be 5% rather than the expected 3%. For example, suppose the price of sparkling water rose from $3 per gallon to $3.15 per gallon. This means that between 2011 and 2012, Caroline's nominal wage ___ by ___ and her real wage ___ by approximately ___.

Answer 1

Answer:

Caroline's paycheck each week is $12 per hour times the number of hours she works. Caroline thus currently earns a NOMINAL wage of $12 per hour. Suppose the price of sparkling water is $3 per gallon. The amount of sparkling water she can buy with her paycheck is 4 GALLONS of sparkling water, which represents her REAL wage.

When workers and firms negotiate compensation packages, they have expectations about the price level (and changes in the price level) and agree on a NOMINAL wage with those expectations in mind. If the price level turns out to be higher than expected, a worker's REAL wage is LOWER than both the worker and employer expected when they agreed to the wage.

Suppose that Caroline and her employer both expected inflation to be 3% between 2011 and 2012. They signed a two-year contract stipulating that Caroline would earn $12 per hour in 2011 and $12.36 per hour in 2012. However, actual inflation between 2011 and 2012 turned out to be 5% rather than the expected 3%. For example, suppose the price of sparkling water rose from $3 per gallon to $3.15 per gallon. This means that between 2011 and 2012, Caroline's nominal wage INCREASED by 3% and her real wage DECREASED by approximately 2%.

Explanation:

Nominal wages are measured in current dollars, while real wages measure the employee's purchasing power. If the inflation rate is higher than expected, the total amount of goods that an employee will be able to purchase will decrease, lowering their real wage.