Macroeconomics Quiz: Price Indices And Inflation
20 questions · exam conditions
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Price Indices And InflationQuestion 1 of 20

A software engineer receives a 5% nominal wage increase. Over the same period, the general price level in the economy rises by 3%. What is the approximate percentage change in the engineer's real wage?

1.94%
2.00%
5.00%
8.00%
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Macroeconomics Quiz

Macroeconomics Quiz: Price Indices And Inflation

Practice Price Indices And Inflation in Macroeconomics with focused quiz questions that help you check what you know, review explanations, and build confidence with test-style prompts.

What this quiz covers

This quiz focuses on Price Indices And Inflation, giving you a quick way to practice the rules, question types, and explanations that matter most for Macroeconomics.

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Try each quiz question before looking at the correct answer. Use the explanations to review missed ideas, then come back to similar questions until the pattern feels familiar.

All questions

Question 1

A software engineer receives a 5% nominal wage increase. Over the same period, the general price level in the economy rises by 3%. What is the approximate percentage change in the engineer's real wage?

  1. 1.94% (correct answer)
  2. 2.00%
  3. 5.00%
  4. 8.00%
Explanation: The change in real wage is determined by the change in the nominal wage relative to the change in the price level (inflation). The exact formula for the new real wage factor is (1 + nominal wage change) / (1 + inflation rate). So, the new real wage is (1.05 / 1.03) ≈ 1.0194 times the old real wage. To find the percentage change, we subtract 1 and multiply by 100: (1.0194 - 1) × 100 = 1.94%. This represents the true increase in purchasing power.

Question 2

An economy's nominal GDP was $1,000 billion in Year 1 when the price index was 125. In Year 2, nominal GDP was $1,200 billion and the price index was 140. What was the percentage change in real GDP between Year 1 and Year 2?

  1. 6.7%
  2. 7.1% (correct answer)
  3. 12.0%
  4. 20.0%
Explanation: This is a two-step problem. First, calculate real GDP for both years using the formula: Real GDP = (Nominal GDP / Price Index) × 100. Real GDP in Year 1 = ($1,000 / 125) × 100 = $800 billion. Real GDP in Year 2 = ($1,200 / 140) × 100 ≈ $857.14 billion. Second, calculate the percentage change in real GDP: % Change = [ (Real GDP Year 2 - Real GDP Year 1) / Real GDP Year 1 ] × 100 % Change = [ ($857.14 - $800) / 800]×100=(800 ] × 100 = (57.14 / $800) × 100 ≈ 7.1%.

Question 3

A manufacturer of candy bars keeps the price of its product constant at $1.50 but reduces the weight of the bar by 10%. How should a perfectly measured price index, which accurately tracks the cost of living, account for this change?

  1. It should show no change in the price level, because the sticker price of the candy bar is unchanged.
  2. It should show a decrease in the price level, because the cost to produce the smaller bar is lower.
  3. It should show an increase in the price level, because the price per unit of weight has increased. (correct answer)
  4. It should not account for the change until the producer officially announces a new product model.
Explanation: This phenomenon, sometimes called 'shrinkflation', is a form of hidden price increase. The consumer is receiving less product for the same amount of money. A perfectly measured price index would account for this by tracking the price per unit of quantity (e.g., price per gram). If the weight decreases by 10% for the same price, the price per gram has increased by approximately 11.1% (since Price/0.9*Weight = 1.11 * Price/Weight). Therefore, the index should record a price increase to accurately reflect the higher cost of living.

Question 4

A key reason that the Personal Consumption Expenditures (PCE) price index, which uses a chain-weighted formula, is often preferred by economists over the traditional fixed-basket CPI is that it:

  1. is calculated and released more frequently, providing more timely data for policymakers.
  2. includes a broader range of goods and services, such as military equipment and exports.
  3. reduces substitution bias by allowing the composition of the representative basket to change over time. (correct answer)
  4. provides a more stable measure of long-run inflation by excluding volatile food and energy prices.
Explanation: The primary methodological advantage of a chain-weighted index like the PCE price index is its ability to mitigate substitution bias. Unlike the CPI's fixed basket, a chain-weighted index updates the weights (expenditure shares) each period. This allows it to capture changes in consumer behavior, such as shifting away from goods whose prices have risen and toward goods whose prices have fallen. This provides a more accurate measure of the change in the true cost of living.

Question 5

An economist argues that the official inflation rate understates the true cost of living increase because it fails to account for 'shrinkflation.' Which of the following best explains this concern and its impact on price indices?

  1. Shrinkflation refers to reduced product quality at constant prices, leading to unmeasured welfare losses not captured in price indices
  2. Shrinkflation involves retailers reducing profit margins to keep prices stable, distorting the relationship between production costs and consumer prices
  3. Shrinkflation describes consumers buying smaller quantities due to budget constraints, biasing the CPI downward through substitution effects
  4. Shrinkflation occurs when package sizes decrease while prices remain constant, effectively raising per-unit costs without affecting the measured CPI (correct answer)
Explanation: When you encounter questions about measurement problems with price indices like the Consumer Price Index (CPI), focus on how real-world pricing strategies can create gaps between what statisticians measure and what consumers actually experience. Shrinkflation is a subtle but important phenomenon where companies reduce product sizes or quantities while keeping prices the same, effectively raising the price per unit without triggering detection in standard price measurements. For example, if a cereal box shrinks from 16 ounces to 14 ounces while maintaining its $4.99 price, the per-ounce cost has increased from about $0.31 to $0.36 — a significant 16% price hike. However, since the CPI tracks the nominal price of "a box of cereal" rather than the price per unit, this increase goes completely unmeasured. This is exactly what answer D describes. Answer A confuses shrinkflation with quality deterioration, which is a separate measurement challenge. Answer B incorrectly suggests shrinkflation involves profit margin reduction — it's actually often a strategy to maintain margins while appearing to hold prices steady. Answer C misidentifies shrinkflation as a demand-side consumer behavior (buying less) rather than a supply-side producer strategy (offering less). The key insight is that shrinkflation allows true inflation to hide within seemingly stable prices, making official inflation statistics understate the real cost of living increases that consumers face. Study tip: Remember that CPI measurement problems often involve the difference between nominal prices (what price tags show) and real value (what consumers actually get for their money).

Question 6

A government bonds analyst notices that 10-year Treasury Inflation-Protected Securities (TIPS) are yielding 1.5% while regular 10-year Treasury bonds yield 4.0%. Six months later, TIPS yields remain at 1.5% but regular Treasury yields have risen to 4.8%. What does this change most likely indicate about inflation expectations?

  1. Expected inflation decreased from 2.5% to 3.3% as bond markets became more concerned about deflationary pressures
  2. Expected inflation became more volatile and uncertain, leading to increased risk premiums across all bond maturities
  3. Expected inflation remained constant while real interest rate expectations increased due to stronger economic growth prospects
  4. Expected inflation increased from 2.5% to 3.3% as investors demanded higher compensation for anticipated price level increases (correct answer)
Explanation: When analyzing bond yields, the key relationship to understand is the Fisher equation: nominal interest rate = real interest rate + expected inflation. TIPS (Treasury Inflation-Protected Securities) provide real returns protected from inflation, while regular Treasury bonds provide nominal returns that include inflation expectations. Initially, regular Treasuries yielded 4.0% while TIPS yielded 1.5%, suggesting expected inflation of 2.5% (4.0% - 1.5%). Six months later, with TIPS unchanged at 1.5% but regular Treasuries rising to 4.8%, the implied inflation expectation increased to 3.3% (4.8% - 1.5%). This 0.8 percentage point increase indicates investors now demand higher compensation for anticipated price increases. Answer D correctly identifies this relationship: expected inflation rose from 2.5% to 3.3% as investors required greater compensation for inflation risk. Answer A incorrectly states inflation expectations decreased and mentions deflationary concerns, which contradicts the higher nominal yields. Answer B focuses on volatility and risk premiums rather than the clear inflation signal from the yield spread. Answer C suggests constant inflation expectations with rising real rates, but since TIPS yields (real rates) remained unchanged at 1.5%, this interpretation is incorrect. Remember this pattern: when TIPS yields stay constant but nominal Treasury yields rise, the widening spread directly reveals increasing inflation expectations. The difference between these two yields always provides a market-based measure of inflation expectations, making this calculation essential for macroeconomic analysis.

Question 7

A statistician is constructing a price index for a small economy and must choose between using geometric mean and arithmetic mean to aggregate individual price changes. If most goods experienced price changes between -2% and +3%, but one essential good (representing 15% of consumption) had a 20% price increase, which method would be more appropriate and why?

  1. Geometric mean would be more appropriate because it reduces the influence of extreme price changes and better reflects typical consumer substitution behavior
  2. Geometric mean would be more appropriate because it provides a more stable index that reduces month-to-month volatility in inflation measurements
  3. Arithmetic mean would be more appropriate because it accurately captures the full impact of essential goods that cannot be easily substituted (correct answer)
  4. Arithmetic mean would be more appropriate because it ensures that all goods receive equal treatment regardless of their individual price volatility
Explanation: When constructing price indices, you need to consider how different averaging methods handle extreme values and what economic behavior they assume. The choice between geometric and arithmetic means fundamentally affects how the index treats large price changes and consumer response patterns. The arithmetic mean is correct here because essential goods with large price increases cannot be easily substituted by consumers. When an essential good representing 15% of consumption experiences a 20% price increase while other goods change only -2% to +3%, this dramatic difference has a real, substantial impact on consumers' cost of living. The arithmetic mean captures this full impact by giving proportional weight to each price change, reflecting the reality that consumers must continue purchasing essential goods despite price spikes. Option A is incorrect because while geometric means do reduce the influence of extreme values, this dampening effect is undesirable when measuring the true cost impact of essential goods. The "substitution behavior" assumption breaks down for necessities. Option B misses the point entirely—the question isn't about volatility smoothing but about accurately measuring cost-of-living changes. Option D incorrectly suggests arithmetic means treat all goods equally; in reality, both methods can incorporate different weights, but arithmetic means better preserve the impact of large changes in weighted components. Remember this key principle: geometric means assume consumers can substitute away from expensive goods, making them suitable for goods with elastic demand. Arithmetic means preserve the full impact of price changes, making them essential when measuring costs for necessities or when substitution isn't realistic.

Question 8

An economy experiences 4% inflation as measured by the CPI, but the central bank's preferred 'trimmed mean' inflation measure shows only 2.8%. If the central bank targets 2% inflation using the trimmed mean measure, what policy implications does this divergence suggest?

  1. Policy should target the higher CPI inflation rate since it better represents the full burden of price increases on consumers
  2. Policy should focus on the 4% CPI rate as it indicates broad-based inflation requiring immediate aggressive monetary tightening
  3. The 2.8% trimmed mean suggests underlying inflation pressures warrant modest policy tightening despite being close to target (correct answer)
  4. The divergence indicates unreliable data quality, suggesting policy should remain unchanged until measurement issues are resolved
Explanation: When you encounter questions about different inflation measures and monetary policy, focus on understanding what each measure captures and how central banks use them for policy decisions. The key insight here is that central banks often prefer "trimmed mean" inflation measures because they filter out temporary price spikes in volatile categories like food and energy, revealing underlying inflation trends. At 2.8%, the trimmed mean is only 0.8 percentage points above the 2% target, suggesting moderate underlying price pressures that warrant gradual policy adjustment rather than aggressive action. Answer C correctly recognizes that the trimmed mean of 2.8% indicates modest inflationary pressure requiring careful, measured tightening. Since this is the central bank's preferred gauge and it's relatively close to target, policy should respond proportionally. Answer A misses that while CPI affects consumers directly, central banks focus on measures that best predict future inflation trends, not just current consumer burden. Answer B incorrectly suggests the 4% CPI rate demands aggressive tightening, but this ignores that the divergence likely reflects temporary volatility in certain sectors rather than broad-based inflation. Answer D wrongly assumes the divergence indicates measurement problems, when it's actually normal and expected—different measures capture different aspects of price changes. Remember this pattern: when you see divergent inflation measures on macro exams, identify which measure the central bank prioritizes and why. Central banks typically favor "core" or "trimmed" measures for policy because they filter out noise and better indicate persistent inflation trends requiring monetary policy response.

Question 9

A central bank targets 2% annual inflation but observes that core inflation is 1.8% while headline inflation is 3.2%. If energy prices, which rose 15% this year, comprise 8% of the consumption basket, what does this suggest about the inflation outlook?

  1. The underlying inflation trend is below target, suggesting the energy price spike is temporary and policy accommodation may be needed (correct answer)
  2. The inflation target is being exceeded sustainably, requiring immediate monetary tightening to prevent expectations from becoming unanchored
  3. The divergence indicates measurement error in the price indices, making policy decisions unreliable until data quality improves
  4. The economy is experiencing demand-pull inflation across all sectors, warranting gradual policy normalization over several quarters
Explanation: Core inflation (1.8%) excludes volatile food and energy prices and is below the 2% target, suggesting underlying price pressures are contained. The high headline inflation (3.2%) is driven by the energy price surge (15% increase on 8% weight contributes about 1.2 percentage points). This suggests temporary supply-side pressures rather than broad-based demand-driven inflation, indicating accommodation may still be appropriate.

Question 10

An investor purchases a corporate bond that pays a nominal interest rate of 7% per year. If the rate of inflation over the year is 4%, what is the exact real rate of return on this investment?

  1. 2.88% (correct answer)
  2. 3.00%
  3. 7.00%
  4. 11.28%
Explanation: The approximate real interest rate is the nominal rate minus the inflation rate (7% - 4% = 3%). However, the question asks for the exact real rate. The formula for the exact real interest rate (r) is given by (1 + r) = (1 + i) / (1 + π), where i is the nominal rate and π is the inflation rate. 1 + r = (1 + 0.07) / (1 + 0.04) = 1.07 / 1.04 ≈ 1.028846. r = 1.028846 - 1 = 0.028846, or approximately 2.88%. The approximation is close but not exact.

Question 11

The GDP deflator for an economy increased from 105 to 110.25 over one year, while the CPI increased from 108 to 113.4 over the same period. What can be concluded from comparing these two inflation measures?

  1. Both measures show identical 5% inflation rates, confirming the accuracy of price level measurements in this economy (correct answer)
  2. The CPI shows higher inflation than the GDP deflator, suggesting import prices rose faster than domestic production costs
  3. The GDP deflator shows higher inflation, indicating that export prices increased more rapidly than consumer prices
  4. The difference reflects measurement error since both indices should theoretically converge to the same inflation rate over time
Explanation: GDP deflator inflation: (110.25/105) - 1 = 5%. CPI inflation: (113.4/108) - 1 = 5%. Both show exactly 5% inflation. While these measures can diverge due to different coverage (GDP deflator covers all domestic production, CPI covers consumer purchases including imports), in this case they happen to show identical rates, confirming consistent price level changes across the economy.

Question 12

The Bureau of Labor Statistics reports that the CPI increased from 240 in January to 244.8 in December of the same year. However, economists note that this annual inflation calculation may be misleading for policy purposes. What is the most likely reason for this concern?

  1. The calculation ignores seasonal adjustments that could reveal underlying inflationary pressures throughout the year
  2. The year-over-year method masks potential monthly volatility and doesn't reflect the compound rate of price increases (correct answer)
  3. The CPI methodology overstates inflation by failing to account for substitution effects when relative prices change
  4. The base year comparison becomes less reliable as the time period extends beyond the original market basket composition
Explanation: The 2% annual inflation rate (244.8/240 = 1.02) calculated this way doesn't show whether inflation was steady throughout the year or volatile. If most price increases occurred late in the year, the monthly compound rate would be much higher than 2% annualized, which is crucial for monetary policy timing. This year-over-year calculation smooths out important monthly variations.

Question 13

A country's statistical office constructs a price index using the Laspeyres method with 2020 as the base year. In 2024, they discover that consumers have significantly shifted their purchasing patterns due to relative price changes. If they were to recalculate the 2024 price index using the Paasche method instead, what would be the most likely result?

  1. The Paasche index would be higher than the Laspeyres index because it captures quality improvements better
  2. The Paasche index would be lower than the Laspeyres index due to substitution bias in the original calculation (correct answer)
  3. The Paasche index would be identical to the Laspeyres index since both use the same price data
  4. The Paasche index would fluctuate unpredictably relative to the Laspeyres index depending on income effects
Explanation: The Laspeyres index uses base-year quantities and tends to overstate inflation because it doesn't account for consumers substituting away from goods that became relatively more expensive. The Paasche index uses current-year quantities, capturing these substitution effects, and typically shows lower inflation rates. This is a well-known bias in price indices when consumption patterns change significantly.

Question 14

Suppose the price of imported avocados doubles, while the price of domestically grown tomatoes remains unchanged. Consumers respond by significantly reducing their avocado consumption and increasing their tomato consumption, maintaining a similar level of overall satisfaction. How would this situation affect the Consumer Price Index (CPI)?

  1. The CPI will understate the true change in the cost of living because it is a fixed-weight index.
  2. The CPI will overstate the true change in the cost of living due to its failure to account for commodity substitution. (correct answer)
  3. The CPI will accurately reflect the change in the cost of living as it includes prices of both imported and domestic goods.
  4. The CPI will be biased due to the quality change bias, as the utility from tomatoes is different from avocados.
Explanation: This scenario describes substitution bias. The CPI is calculated using a fixed basket of goods and services. When the price of one good (avocados) rises, consumers substitute toward a relatively cheaper good (tomatoes). The CPI, by using the original, fixed quantities, does not account for this change in purchasing behavior. Therefore, it measures a larger price increase than what consumers actually experience, overstating the true increase in the cost of living.

Question 15

A student takes out a four-year university loan at a fixed nominal interest rate of 5%. For the next four years, the economy experiences an average inflation rate of 8% per year, which was much higher than what economists and lenders had expected. What is the most significant consequence of this situation?

  1. The real interest rate on the loan is positive, increasing the burden on the student.
  2. The real value of the student's loan payments decreases, effectively transferring wealth from the lender to the student. (correct answer)
  3. Both the student and the lender are made worse off because the high inflation erodes the value of all financial assets.
  4. The nominal value of the loan decreases over time, reducing the total amount the student must repay.
Explanation: The real interest rate is approximately the nominal interest rate minus the inflation rate (5% - 8% = -3%). Because the inflation rate (8%) is higher than the fixed nominal interest rate (5%), the real interest rate is negative. This means the payments the student makes back to the lender are worth less in real, purchasing power terms than the money the student originally borrowed. This unanticipated inflation results in a redistribution of wealth from the lender (who is being paid back with less valuable dollars) to the borrower (the student).

Question 16

In 1965, a gallon of gasoline cost approximately $0.30. In that year, the Consumer Price Index (CPI) was 31.5. If the CPI in the current year is 297.7, what is the 1965 price of gasoline expressed in current year dollars, rounded to the nearest cent?

  1. $0.03
  2. $2.84 (correct answer)
  3. $3.15
  4. $8.75
Explanation: To convert a price from a past year to current dollars, use the formula: Price in current =Priceinpast= Price in past × (Current CPI / Past CPI). Price in current $ = $0.30 × (297.7 / 31.5) = $0.30 × 9.4507... ≈ $2.84. This calculation shows what the 1965 price would be if it had increased at the same rate as the average consumer price level.

Question 17

A pension payment of $3,000 per month is indexed to the Consumer Price Index (CPI) to maintain the recipient's purchasing power. At the beginning of Year 1, the CPI is 280.0. At the end of Year 1, the CPI has risen to 294.0. What will the new monthly pension payment be for Year 2?

  1. $3,014.00
  2. $3,142.86
  3. $3,150.00 (correct answer)
  4. $3,294.00
Explanation: The pension is adjusted based on the percentage change in the CPI (the inflation rate). First, calculate the inflation rate for Year 1: Inflation Rate = [ (New CPI - Old CPI) / Old CPI ] × 100 Inflation Rate = [ (294.0 - 280.0) / 280.0 ] × 100 = (14.0 / 280.0) × 100 = 5%. Next, increase the pension payment by this percentage: New Payment = Old Payment × (1 + Inflation Rate) New Payment = $3,000 × (1 + 0.05) = $3,000 × 1.05 = $3,150.00.

Question 18

In a given month, an economy experiences a sharp rise in global energy prices due to a supply disruption and a simultaneous fall in food prices due to an exceptional harvest. The prices of all other goods and services, including housing and medical care, increase slightly. Given this information, which of the following statements is the most likely description of the headline CPI and core CPI?

  1. Headline CPI will rise sharply, while core CPI will fall.
  2. Headline CPI will fall due to the harvest, while core CPI will rise sharply due to the energy shock.
  3. Both headline CPI and core CPI will rise slightly, as the opposing effects of food and energy cancel each other out.
  4. Core CPI will rise slightly, while the change in headline CPI is uncertain without knowing the weights of food and energy. (correct answer)
Explanation: When analyzing inflation measures, you need to distinguish between headline CPI (which includes all goods and services) and core CPI (which excludes the volatile food and energy sectors). This distinction is crucial because food and energy prices can fluctuate dramatically due to temporary factors, potentially masking underlying inflation trends. Let's trace through the scenario: Core CPI will definitely rise slightly because all non-food, non-energy prices increased slightly. Since core CPI excludes food and energy entirely, the dramatic changes in those sectors don't affect it at all. For headline CPI, you have competing forces: energy prices rising sharply (inflationary) versus food prices falling sharply (deflationary), plus slight increases in everything else. Without knowing the relative weights of food and energy in the CPI basket, you cannot determine which force dominates. If energy has a larger weight than food, headline CPI rises; if food has a larger weight, headline CPI falls. Choice A incorrectly suggests core CPI would fall, but core CPI only reflects the slight increases in non-food, non-energy items. Choice B wrongly claims headline CPI will definitely fall and core CPI will rise sharply, but core CPI excludes energy entirely. Choice C assumes the food and energy effects will perfectly cancel out, which requires knowing their exact weights and price changes. Remember this pattern: core CPI is more predictable because it excludes volatile components, while headline CPI's direction depends on the relative magnitude and weights of all price changes, especially in food and energy.

Question 19

Suppose in Scenario A, the CPI increases from 100 to 110 in one year. In Scenario B, the CPI increases from 200 to 220 in one year. Which of the following statements accurately compares the two scenarios?

  1. The inflation rate is higher in Scenario B than in Scenario A.
  2. The purchasing power of a dollar fell by a larger percentage in Scenario B.
  3. The absolute dollar cost of the CPI market basket increased by the same amount in both scenarios.
  4. The inflation rate is the same in both scenarios, but the absolute cost of the market basket increased by twice as much in Scenario B. (correct answer)
Explanation: First, calculate the inflation rate for both scenarios. Scenario A: Inflation = [(110 - 100) / 100] × 100 = 10%. Scenario B: Inflation = [(220 - 200) / 200] × 100 = 10%. The inflation rate is the same in both. However, the CPI level represents the cost of the market basket relative to a base period. A CPI of 200 means the basket costs twice as much as it did in the base period. The absolute increase in the index is 10 points in A and 20 points in B. This means the dollar cost of the basket increased by twice as much in Scenario B as it did in Scenario A, even though the percentage increase (inflation) was identical.

Question 20

In the short run, many employment contracts are based on fixed nominal wages. If an economy experiences a period of unexpectedly high inflation, what is the most likely immediate consequence for firms' real labor costs and their corresponding level of production?

  1. Real labor costs increase, leading firms to decrease production.
  2. Real labor costs decrease, but firms decrease production due to increased economic uncertainty.
  3. Real labor costs are unchanged because wages are fixed, leading to no change in production.
  4. Real labor costs decrease, leading firms to increase production. (correct answer)
Explanation: When you encounter questions about wage contracts and inflation, focus on the relationship between nominal wages, real wages, and how this affects firm behavior. The key insight is understanding what happens when prices rise but wages are fixed by contract. Real labor costs represent what firms actually pay workers in terms of purchasing power. When inflation is unexpectedly high, prices throughout the economy rise, but nominal wages remain fixed due to existing contracts. This creates a gap: while firms can sell their output at higher prices due to inflation, they're still paying the same nominal wages. In real terms (adjusted for the new price level), firms are paying workers less, meaning their real labor costs decrease. With lower real labor costs and higher output prices, firms face improved profit margins, incentivizing them to increase production. Option A incorrectly suggests real labor costs increase – this would only happen if nominal wages rose faster than inflation, which can't occur with fixed wage contracts. Option B correctly identifies that real labor costs decrease but wrongly concludes firms would reduce production; lower costs typically encourage expansion, not contraction. Option C misunderstands that "fixed nominal wages" doesn't mean "fixed real wages" – when the price level changes, real wages change even if nominal wages don't. The correct answer is D: real labor costs decrease, leading firms to increase production. Remember this pattern: unexpected inflation with fixed nominal wage contracts creates a temporary advantage for firms through lower real labor costs, typically stimulating short-run production increases until wages can be renegotiated.