Application Exercise 10c
- Explain whether Priyanka is earning an If so, identify the type of income being earned.
Priyanka is earning an income. It is interest – which is a type of factor income, because it is a return on her savings. She has invested money, and receives income on that money.
- Explain whether Priyanka should be happy with the additional $12,500.
Priyanka should be happy with the additional $12,500 (a 5% return) if the current rate of inflation (rise in average prices over the year) is less than 5% and if other possible ways of investing her money would have yielded a smaller rate of return (smaller income) than received on her investment.
- Explain why your answer in Question 2 might be different if you were advised that the rate of inflation over 2023 was 5%. (Hint: Would Priyanka be able to buy more goods and services with the money in her bank account at the end of 2023 when compared to the start of 2022?)
If the rate of inflation over 2023 was 5% then the value of Priyanka’s investment will not have grown in real terms. It will only have grown in nominal terms. That is, the dollar value of her investment will have risen by 5%, but the purchasing power of her investment will not have risen. This is because most things that Priyanka could buy with the money she earned will have gone up in price in line with the rise in her income. Priyanka would not be able to buy more goods and services with the money in her bank account at the end of 2023 when compared to the start of 2022.
- Explain why Priyanka should be unhappy if the inflation rate over 2023 was 10%. In your answer, refer to nominal and real
If the inflation rate was even higher at 10% then the value of Priya’s investment will have fallen in real terms. It will have risen by 5% in nominal terms, but the total value of her investment in real terms will have fallen (in terms of her command over goods and services, also known as her purchasing power.)
- Discuss why Charlotte is unhappy with a reduction in the size of her annual wage
Most income earners desire to increase (or at an absolute minimum, preserve) the purchasing power of their income. If the inflation rate over 2023 was actually 5% (as per question 3), then her capacity to buy goods and services would have fallen, since her nominal income has risen by only 3%, which is less than the rise in average prices (5%), meaning her real income has fallen.
- Explain why your answer in Question 5 might be different if Charlotte anticipated that the inflation rate over the course of 2023 would have fallen to 3%.
If inflation were only 3% over 2023, then at least Charlotte’s real income has been preserved, since the increase in her income is equal to the rise in average prices, maintaining her purchasing power. Nevertheless, even if inflation were not as high as 5% and was only 3%, most workers desire to increase their income over time, and the fall in the rate of increase in her income would be disappointing. Charlotte is likely to still be disappointed that her income has not risen in real terms.