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Chapter 18: Q10. (page 389)

Suppose that firms were expecting inflation to be 3 percent, but it actually turned out to be 7 percent. Other things equal, firm profits will be:

a. smaller than expected

b. larger than expected

Short Answer

Expert verified

The correct option is (b).

Step by step solution

01

The explanation for correct option (b)

The changes in the inflation rate affect the profit level of the firms. According to the question, the expected inflation rate was 3 percent. So the workers would set the nominal wages based on a 3 percent inflation rate. Now, if the actual inflation rate rises by 7 percent while nominal wages are rigid, it would lead to a rise in the firm鈥檚 profit level. In response to higher profits, the firms would hire more workers and produce more output.

Thus price and output level are positively related in the short run. It indicates that the firm鈥檚 profit would rise in response to a rise in the actual inflation rate. So option b) is correct.

02

The explanation for incorrect option (a)

Option a) is incorrect because the firms generally fix the input price (nominal wages) based on the expected inflation rate. So if the actual inflation rate is higher than the expected inflation rate, then the output price rises while the cost of production remains the same. So the firms would receive higher profits and not lower. Hence option a) is incorrect.

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Most popular questions from this chapter

Use graphical analysis to show how each of the following will affect the economy, first in the short run and then in the long run. Assume that the United States is initially operating at its full-employment level of output, that prices and wages are eventually flexible both upward and downward, and that there is no counteracting fiscal or monetary policy.

a. Because of a war abroad, the oil supply to the United States is disrupted, sending oil prices rocketing upward.

b. Construction spending on new homes rises dramatically, greatly increasing total U.S. investment spending.

c. Economic recession occurs abroad, significantly reducing foreign purchases of U.S. exports

Suppose that over a 30-year period Buskerville鈥檚 price level increased from 72 to 138, while its real GDP rose from \(1.2 trillion to \)2.1 trillion. Did economic growth occur in Buskerville? If so, by what average yearly rate in percentage terms (rounded to one decimal place)? Did Buskerville experience inflation? If so, by what average yearly rate in percentage terms (rounded to one decimal place)? Which shifted rightward faster in Buskerville: its long-run aggregate supply curve (ASLR) or its aggregate demand curve (AD)?

Suppose that firms are expecting 6 percent inflation while workers are expecting 9 percent inflation. How much of a pay raise will workers demand if their goal is to maintain the purchasing power of their incomes?

a. 3 percent

b. 6 percent

c. 9 percent

d. 12 percent

What do the distinctions between short-run aggregate supply and long-run aggregate supply have in common with the distinction between the short-run Phillips Curve and the long-run Phillips Curve? Explain.

Suppose that for years East Confetti鈥檚 short-run Phillips Curve was such that each 1 percentage point increase in its unemployment rate was associated with a 2 percentage point decline in its inflation rate. Then, during several recent years, the short-run pattern changed such that its inflation rate rose by 3 percentage points for every 1 percentage point drop in its unemployment rate. Graphically, did East Confetti鈥檚 Phillips Curve shift upward or did it shift downward? Explain.
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