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Suppose you’ll have an annual nominal income of $65,000 for each of the next three years, and the inflation rate is 5 percent per year.

Required:
a. Find the real value of your $65,000 salary for each of the next three years.
b. If you have a COLA in your contract, and the inflation rate is 5 percent per year, what is the real value of your salary of 70.000 for each year?

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Answer:

a) real income in one year = $65,000/1.05 = $61,904.76

real income in two year = $65,000/1.05² = $58,956.92

real income in three year = $65,000/1.05³ = $56,149.44

b) if you have a COLA agreement, then your salary will adjust to inflation. This means that your real salary will remain the same during the 3 years = $70,000 per year.

In this case, your nominal salary will increase by 5% each year, but your salary will remain equal.

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