contemporary engineering economics, 4 th edition, © 2007 meaning and measure of inflation lecture...

Contemporary Engineering

Economics, 4th edition, © 2007

Meaning and Measure of Inflation

Lecture No. 43Chapter 11Contemporary Engineering EconomicsCopyright © 2006



Chapter Opening Story – How Much Will It Cost to Send Your Child to College in Year 2015? A year in college cost

$17,800 in 2005. Due to inflation, the

college expense has been increasing at a rate of 6.5% annually.

Then, in 2015 a year in college would cost about $33,413.



What is inflation?

How do we measure inflation?

How do we incorporate the effect of inflation in equivalence calculation?

Inflation and Economic Analysis



Value of Money

Earning Power

Purchasing Power

Earning PowerPurchasing power

Investment Opportunity

Decrease in purchasing power (inflation)Increase in Purchasing Power (deflation)

What is Inflation?Inflation is the rate at which the general level of prices and goods and services is rising, and subsequently, purchasing power is falling.



1990

$100

1990 2006

$100

You could buy 50 Big Macs in year 1990.

You can only buy 28.5 Big Macs in year 2006.

$2.00 / unit $3.50 / unit75% Price change due to inflation

The $100 in year 2006 has only $57 worth purchasing power of 1990

Purchasing Power



2004 2005 2006 2007

$100

2004 2005 2006 2007

$100

You could purchase 63.69 gallons of purified drink water a year ago.

You can now purchase 80 gallons of purifieddrink water.

$1.57 / gallon $1.25 / gallonPrice change due to

deflation

20.38%

Deflation



Inflation Terminology - I

Producer Price Index: a statistical measure of industrial price change, compiled monthly by the Bureau of Labor Statistics, U.S. Department of Labor

Consumer Price Index: a statistical measure of change, over time, of the prices of goods and services in major expenditure groups—such as food, housing, apparel, transportation, and medical care—typically purchased by urban consumers

Average Inflation Rate (f): a single rate that accounts for the effect of varying yearly inflation rates over a period of several years.

General Inflation Rate (f ): the average inflation rate calculated based on the CPI for all items in the market basket.



Consumer Price Index (CPI): the CPI compares the cost of a sample “market basket” of goods and services in a specific period relative to the cost of the same “market basket” in an earlier reference period. This reference period is designated as the base period. Market basket

Base Period (1982-84) 2006

$100 $203.5 (July)

CPI for 2006 = 203.5

Consumer Price Index



Selected Price Indexes (Index for Base Year = 100, Calendar Month = April)



Fact: Base Price = $100 (year 0)Inflation rate (year 1) = 4%Inflation rate (year 2) = 8%Average inflation rate over 2 years?

Step 1: Find the actual inflated price at the end of year 2.

$100 ( 1 + 0.04) ( 1 + 0.08) = $112.32

Step 2: Find the average inflation rate by solving the following equivalence equation.

$100 ( 1+ f) = $112.32f = 5.98%

2

$100

$112.32

0 1

2

Average Inflation Rate (f )



Example 11.1 Average Inflation Rate



Average inflation rate based on the CPI

CPI CPI f

fCPI

CPI

f

CPI n

CPI

nn

n

n

n

LNM

OQP

0

0

1

0

1

1

( ) ,_

_/

_

where The genreal inflation rate,

The consumer price index at the end period ,

The consumer price index for the base period.

General Inflation Rate (f)



Year Cost

0 $504,000

1 538,000

2 577,000

3 629,500

What are the annual inflation ratesand the average inflation rate over 3 years?

SolutionInflation rate during year 1 (f1): ($538,400 - $504,000) / $504,000 = 6.83%.Inflation rate during year 2 (f2): ($577,000 - $538,400) / $538,400 = 7.17 %.Inflation rate during year 3 (f3): ($629,500 - $577,000) / $577,000 = 9.10%.The average inflation rate over 3 years is

f ($629,

$504,) . ./500

0001 0 0769 7 69%1 3

Example 11.2: Yearly and Average Inflation Rates



Inflation Terminology – II Actual Dollars (An ): Estimates of future cash

flows for year n that take into account any anticipated changes in amount caused by inflationary or deflationary effects.

Constant Dollars (An’ ): Estimates of future cash flows for year n in constant purchasing power, independent of the passage of time (or base period).



A A f A F P f nn nn

n ' ( ) ' ( / , , )_ _

1

$1,000 (1 + 0.08)= $1,260

3ConstantDollars

n

f

3

8%_

$1,000

3ActualDollars

$1,260

3

Conversion from Constant to Actual Dollars



Period Net Cash Flow in Constant $

Conversion Factor

Cash Flow in Actual $

0 -$250,000 (1+0.05)0 -$250,000

1 100,000 (1+0.05)1 105,000

2 110,000 (1+0.05)2 121,275

3 120,000 (1+0.05)3 138,915

4 130,000 (1+0.05)4 158,016

5 120,000 (1+0.05)5 153,154

Conversion from Constant to Actual DollarsAverage inflation rate = 5%



A A f A P F f nn nn

n' ( ) ( / , , )_ _

1

ConstantDollars $1,260 (1 + 0.08)

= $1,000

-3

n

f

3

8%_

$1,000

3ActualDollars

$1,260

3

Conversion from Actual to Constant Dollars



End of period

Cash Flow in Actual $

Conversion at f = 5%

Cash Flow in Constant $

Loss in Purchasing

Power

0 -$20,000 (1+0.05)0 -$20,000 0%

1 20,000 (1+0.05)-1 -19,048 4.76

2 20,000 (1+0.05)-2 -18,141 9.30

3 20,000 (1+0.05)-3 -17,277 13.62

4 20,000 (1+0.05)-4 -16,454 17.73

Conversion from Actual to Constant Dollars



Example 11.3 Conversion from Constant to Actual Dollars

Jack Nicklaus won his first MastersGolf Championship in 1963. The prize money was $20,000.

Phil Mickelson won his first Masters Golf Championship in 2004.The prize money was $1.17M.

1963 2004

What is the worth of $20,000 in terms of purchasing power in 2004?



Consumer Price Indexes for 1963 and 2004

1963

91.7

2004

561.23

1967

100

Average inflation rate = 4.52%

41

41

561.23 91.70(1 )

6.1203 1

4.5176%

f

f



$20,000 in 1963 would have a purchasing power of $122,760 in 2004The average inflation rate between

1963 and 2004 was about 4.52% per year.



What Could Jack Have Done to Match the Phil’s Prize Money?

01963

41

2004

$20,000

$1.17M

2004 $20,000( / , , 41)

$1,170,000

10.43%

F F P i

i

What it means is that if Jackwere able to invest his prize moneyat an interest of 10.43%over 41 years, he could match Phil’s prize money.

contemporary engineering economics, 4 th edition, © 2007 meaning and measure of inflation lecture...

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