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The real wage ($$w$$) represents the purchasing power of a worker's earnings and is defined as the nominal wage ($$W$$) divided by the overall price level ($$P$$). This relationship is expressed by the formula:

$$w = \frac{W}{P}$$

This relationship is a foundational assumption within the Wage-Setting/Price-Setting (WS-PS) model.

Real Wage Formula

Analyze the following scenario and explain the effect on the workers' purchasing power over the course of their contract.

Impact of Unexpected Inflation on Labor Contracts

An economy experiences a year where the average nominal wage for workers increases by 4%. However, at the end of the year, the average worker finds that their ability to purchase goods and services has actually decreased. Explain, using the relationship between nominal earnings, real earnings, and the price level, how this scenario is possible.

Nominal vs. Real Wage Changes

If a worker's nominal wage increases by 4% in a year, but the overall price level increases by 6% during the same period, then the worker's real wage has increased.

An employee receives a 5% increase in their yearly salary. During the same year, the general level of prices for goods and services increases by 3%. How has the employee's actual purchasing power changed?

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