price & exchange rates

8/13/2019 Price & Exchange Rates

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CHAPTER 7CHAPTER 7CHAPTER 7CHAPTER 7

PRICE CHANGES ANDPRICE CHANGES AND

EXCHANGE RATESEXCHANGE RATES

PRICE CHANGES ANDPRICE CHANGES AND

EXCHANGE RATESEXCHANGE RATES


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GENERAL PRICE INFLATIONGENERAL PRICE INFLATIONGENERAL PRICE INFLATIONGENERAL PRICE INFLATION

An increase in the average priceAn increase in the average pricepaid for goods and servicespaid for goods and servicesAn increase in the average priceAn increase in the average pricepaid for goods and servicespaid for goods and services

purchasing power of money.purchasing power of money.purchasing power of money.purchasing power of money.


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GENERAL PRICE DEFLATIONGENERAL PRICE DEFLATIONGENERAL PRICE DEFLATIONGENERAL PRICE DEFLATION

A decrease in the averageA decrease in the averageprice paid for goods inprice paid for goods inA decrease in the averageA decrease in the averageprice paid for goods inprice paid for goods in

serv ces, resu ng n anserv ces, resu ng n anincrease in the purchasingincrease in the purchasingpower of money.power of money.

serv ces, resu ng n anserv ces, resu ng n anincrease in the purchasingincrease in the purchasingpower of money.power of money.


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CONSUMER PRICE INDEXCONSUMER PRICE INDEX

(CPI)(CPI)

CONSUMER PRICE INDEXCONSUMER PRICE INDEX

(CPI)(CPI) One measure of price changes in ourOne measure of price changes in oureconomyeconomy

An estimate of general price inflationAn estimate of general price inflation

One measure of price changes in ourOne measure of price changes in oureconomyeconomy

An estimate of general price inflationAn estimate of general price inflation

A composite price index that measuresA composite price index that measuresprice changes in food, shelter, medicalprice changes in food, shelter, medicalcare, transportation, apparel, andcare, transportation, apparel, and otherotherselectedselected goods and services used bygoods and services used byaverage individuals and familiesaverage individuals and families

A composite price index that measuresA composite price index that measuresprice changes in food, shelter, medicalprice changes in food, shelter, medicalcare, transportation, apparel, andcare, transportation, apparel, and otherotherselectedselected goods and services used bygoods and services used byaverage individuals and familiesaverage individuals and families


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CONSUMER PRICE INDEXCONSUMER PRICE INDEXCONSUMER PRICE INDEXCONSUMER PRICE INDEX

CPICPIkk= (= (SQQkk--11x Px Pkk) / () / (SQQkk--11x Px Pkk--11)) QQkk--11= Preceding year quantities= Preceding year quantities

== --

CPICPIkk= (= (SQQkk--11x Px Pkk) / () / (SQQkk--11x Px Pkk--11)) QQkk--11= Preceding year quantities= Preceding year quantities

== --

PPkk--11= Preceding Year Prices= Preceding Year Prices

CPI Annual Inflation RateCPI Annual Inflation Rate

= [ (CPI= [ (CPIkk-- CPICPIkk--11) / CPI) / CPIkk--11 ] x 100] x 100 CPICPIkk= Consumer price index for the current year= Consumer price index for the current year

CPICPIkk--11 = Consumer price index for the preceding year= Consumer price index for the preceding year

PPkk--11= Preceding Year Prices= Preceding Year Prices

CPI Annual Inflation RateCPI Annual Inflation Rate

= [ (CPI= [ (CPIkk-- CPICPIkk--11) / CPI) / CPIkk--11 ] x 100] x 100 CPICPIkk= Consumer price index for the current year= Consumer price index for the current year

CPICPIkk--11 = Consumer price index for the preceding year= Consumer price index for the preceding year


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OTHER INFLATION INDICATORSOTHER INFLATION INDICATORSOTHER INFLATION INDICATORSOTHER INFLATION INDICATORS

While the CPI is shows how the prices thatWhile the CPI is shows how the prices thatconsumers pay change from year to year orconsumers pay change from year to year ormonth to monthmonth to month

The PPI (Producer Price Index) shows howThe PPI (Producer Price Index) shows how

While the CPI is shows how the prices thatWhile the CPI is shows how the prices thatconsumers pay change from year to year orconsumers pay change from year to year ormonth to monthmonth to month

The PPI (Producer Price Index) shows howThe PPI (Producer Price Index) shows how

year to year or month to monthyear to year or month to month

The Implicit Price Deflator or GDP deflatorThe Implicit Price Deflator or GDP deflatorshows how all prices in the economyshows how all prices in the economychange from one time period to anotherchange from one time period to anothertime periodtime period

year to year or month to monthyear to year or month to month

The Implicit Price Deflator or GDP deflatorThe Implicit Price Deflator or GDP deflatorshows how all prices in the economyshows how all prices in the economychange from one time period to anotherchange from one time period to anothertime periodtime period


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INFLATIONINFLATION--RELATED TERMINOLOGYRELATED TERMINOLOGYINFLATIONINFLATION--RELATED TERMINOLOGYRELATED TERMINOLOGY Actual dollars (A$)Actual dollars (A$) -- (Current time frame) cash(Current time frame) cash--

flow dollarsflow dollars:: alsoalso current dollars, thencurrent dollars, then--current dollars,current dollars,or inflated dollarsor inflated dollars

Real dollars (R$)Real dollars (R$) -- Dollars in terms of purchasingDollars in terms of purchasingpower at some stated time period (i.e., base year):power at some stated time period (i.e., base year):also constant dollarsalso constant dollars

Base period (b)Base period (b) -- PurchasingPurchasing--power timepower time

Actual dollars

(A$)Actual dollars (A$) -- (Current time frame) cash(Current time frame) cash--flow dollarsflow dollars:: alsoalso current dollars, thencurrent dollars, then--current dollars,current dollars,or inflated dollarsor inflated dollars

Real dollars (R$)Real dollars (R$) -- Dollars in terms of purchasingDollars in terms of purchasingpower at some stated time period (i.e., base year):power at some stated time period (i.e., base year):also constant dollarsalso constant dollars

Base period (b)Base period (b) -- PurchasingPurchasing--power timepower time

referencereference

General price inflation ( f )General price inflation ( f ) -- Measure of change inMeasure of change inpurchasing power from one time to anotherpurchasing power from one time to another

Combined (nominal) interest rate ( iCombined (nominal) interest rate ( icc)) -- MarketMarket

interest rate: actual dollars paid for use of capitalinterest rate: actual dollars paid for use of capital Real interest rateReal interest rate -- (i(irr)) -- InflationInflation--free interest rate:free interest rate:

real dollars paid for use of capitalreal dollars paid for use of capital

referencereference

General

price inflation ( f )General price inflation ( f ) -- Measure of change inMeasure of change inpurchasing power from one time to anotherpurchasing power from one time to another

Combined (nominal) interest rate ( iCombined (nominal) interest rate ( icc)) -- MarketMarket

interest rate: actual dollars paid for use of capitalinterest rate: actual dollars paid for use of capital Real interest rateReal interest rate -- (i(irr)) -- InflationInflation--free interest rate:free interest rate:

real dollars paid for use of capitalreal dollars paid for use of capital


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RELATING ACTUAL DOLLARS TO REALRELATING ACTUAL DOLLARS TO REALDOLLARSDOLLARS

RELATING ACTUAL DOLLARS TO REALRELATING ACTUAL DOLLARS TO REALDOLLARSDOLLARS

Use the following to convert actual dollars, as ofUse the following to convert actual dollars, as of

time k, to real dollars of constant purchasingtime k, to real dollars of constant purchasingpowerpower

(R$)(R$)KK= (A$)= (A$)KK [1/ (1+f)][1/ (1+f)]KK--bb

= (A$)= (A$)KK(P / F, f %, k(P / F, f %, k--b)b)

Use the following to convert actual dollars, as ofUse the following to convert actual dollars, as of

time k, to real dollars of constant purchasingtime k, to real dollars of constant purchasingpowerpower

(R$)(R$)KK= (A$)= (A$)KK [1/ (1+f)][1/ (1+f)]KK--bb

= (A$)= (A$)KK(P / F, f %, k(P / F, f %, k--b)b) e equa on c anges as o ows or a spec ce equa on c anges as o ows or a spec c

type cash flow (i.e. specific good or service type cash flow (i.e. specific good or service ) )(R$)(R$)KK = (A$)= (A$)KK [1/ (1+f)][1/ (1+f)]KK--bb

= (A$)= (A$)KK (P / F, f %, k(P / F, f %, k--b)b) In the base period, purchasing power of actualIn the base period, purchasing power of actual

dollar and real dollar are the samedollar and real dollar are the same

e equa on c anges as o ows or a spec ce equa on c anges as o ows or a spec ctype cash flow (i.e. specific good or service type cash flow (i.e. specific good or service ) )

(R$)(R$)KK = (A$)= (A$)KK [1/ (1+f)][1/ (1+f)]KK--bb= (A$)= (A$)KK (P / F, f %, k(P / F, f %, k--b)b)

In the base period, purchasing power of actualIn the base period, purchasing power of actualdollar and real dollar are the samedollar and real dollar are the same


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RELATING COMBINED AND REAL INTERESTRELATING COMBINED AND REAL INTERESTRATES AND GENERAL INFLATION RATERATES AND GENERAL INFLATION RATE

RELATING COMBINED AND REAL INTERESTRELATING COMBINED AND REAL INTERESTRATES AND GENERAL INFLATION RATERATES AND GENERAL INFLATION RATE

ii rr= ( i= ( i cc-- f ) / ( 1 + f )f ) / ( 1 + f )

Similarly, currentSimilarly, current--dollar internal ratedollar internal rate

ii rr= ( i= ( i cc-- f ) / ( 1 + f )f ) / ( 1 + f )

Similarly, currentSimilarly, current--dollar internal ratedollar internal rate

return in the following way:return in the following way:

IRRIRR rr= (IRR= (IRR cc-- f ) / ( 1 + f )f ) / ( 1 + f )

return in the following way:return in the following way:

IRRIRR rr= (IRR= (IRR cc-- f ) / ( 1 + f )f ) / ( 1 + f )


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FIXED AND RESPONSIVEFIXED AND RESPONSIVE

ANNUITIESANNUITIES

FIXED AND RESPONSIVEFIXED AND RESPONSIVE

ANNUITIESANNUITIES Cash flows predetermined byCash flows predetermined by

contractcontract ---- bonds or fixed annuitiesbonds or fixed annuities ----

do not res ond to eneral ricedo not res ond to eneral rice

Cash flows predetermined byCash flows predetermined bycontractcontract ---- bonds or fixed annuitiesbonds or fixed annuities ----

do not res ond to eneral ricedo not res ond to eneral riceinflationinflation

Future amounts that are notFuture amounts that are notpredetermined may, by varyingpredetermined may, by varying

degrees, respond to general pricedegrees, respond to general priceinflationinflation

inflationinflation

Future amounts that are notFuture amounts that are notpredetermined may, by varyingpredetermined may, by varying

degrees, respond to general pricedegrees, respond to general priceinflationinflation


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CALCULATING AN EFFECTIVE GENERALCALCULATING AN EFFECTIVE GENERALPRICE INFLATION RATEPRICE INFLATION RATE

CALCULATING AN EFFECTIVE GENERALCALCULATING AN EFFECTIVE GENERALPRICE INFLATION RATEPRICE INFLATION RATE

f = An (estimated) effective general pricef = An (estimated) effective general priceinflation rate for a period of N yearsinflation rate for a period of N years

1 / N1 / N f = An (estimated) effective general pricef = An (estimated) effective general price

inflation rate for a period of N yearsinflation rate for a period of N years

1 / N1 / Nf =f = k=1k=1( 1 + f( 1 + f kk )) -- 11f =f = k=1k=1( 1 + f( 1 + f kk )) -- 11


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DIFFERENTIAL PRICE INFLATIONDIFFERENTIAL PRICE INFLATIONDIFFERENTIAL PRICE INFLATIONDIFFERENTIAL PRICE INFLATION

Variation between general price inflation rate andVariation between general price inflation rate andthe best estimate of future price changes forthe best estimate of future price changes forspecific goods and servicesspecific goods and services

ee II ---- The increment ( % ) of price change aboveThe increment ( % ) of price change aboveor below the eneral rice inflation rate for aor below the eneral rice inflation rate for a

Variation between general price inflation rate andVariation between general price inflation rate andthe best estimate of future price changes forthe best estimate of future price changes forspecific goods and servicesspecific goods and services

ee II ---- The increment ( % ) of price change aboveThe increment ( % ) of price change aboveor below the eneral rice inflation rate for aor below the eneral rice inflation rate for agiven time period for good or service given time period for good or service

Caused by: changes in supply, changes inCaused by: changes in supply, changes indemand, technological improvements,demand, technological improvements,productivity changes, regulatory requirementsproductivity changes, regulatory requirements

given time period for good or service given time period for good or service Caused by: changes in supply, changes inCaused by: changes in supply, changes in

demand, technological improvements,demand, technological improvements,productivity changes, regulatory requirementsproductivity changes, regulatory requirements


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TOTAL PRICE ESCALATIONTOTAL PRICE ESCALATIONTOTAL PRICE ESCALATIONTOTAL PRICE ESCALATION

Price changes caused by some combination ofPrice changes caused by some combination ofgeneral price and differential price inflationgeneral price and differential price inflation

ee ---- The total rate (%) of price change during aThe total rate (%) of price change during atime period for good or service time period for good or service

Price changes caused by some combination ofPrice changes caused by some combination ofgeneral price and differential price inflationgeneral price and differential price inflation

ee ---- The total rate (%) of price change during aThe total rate (%) of price change during atime period for good or service time period for good or service inflation rate ( f ) and the differential price inflationinflation rate ( f ) and the differential price inflation

rate (erate (e II ) on price changes) on price changes

ee II = ( e= ( e -- f ) / ( 1 + f )f ) / ( 1 + f )

(A$)(A$) kk = (A$)= (A$) bb (F / P, e(F / P, e %, k%, k -- b )b )(A$)(A$) bb = (A$)= (A$) bb (F / P, e(F / P, e II %, k%, k -- b )b )

inflation rate ( f ) and the differential price inflationinflation rate ( f ) and the differential price inflation

rate (erate (e II ) on price changes) on price changes

ee II = ( e= ( e -- f ) / ( 1 + f )f ) / ( 1 + f )

(A$)(A$) kk = (A$)= (A$) bb (F / P, e(F / P, e %, k%, k -- b )b )(A$)(A$) bb = (A$)= (A$) bb (F / P, e(F / P, e II %, k%, k -- b )b )


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DETERMINING A CONVENIENCE RATEDETERMINING A CONVENIENCE RATEFOR GEOMETRIC CASH FLOWFOR GEOMETRIC CASH FLOW

SEQUENCESSEQUENCES

DETERMINING A CONVENIENCE RATEDETERMINING A CONVENIENCE RATEFOR GEOMETRIC CASH FLOWFOR GEOMETRIC CASH FLOW

SEQUENCESSEQUENCES

Actual dollar analysis ( A$ )Actual dollar analysis ( A$ )

iiCRCR= ( i= ( icc-- ee ) / ( 1 + e) / ( 1 + e )) Actual dollar analysis ( A$ )Actual dollar analysis ( A$ )

iiCRCR= ( i= ( icc-- ee ) / ( 1 + e) / ( 1 + e )) Real dollar analysis ( R$ )Real dollar analysis ( R$ )

iiCRCR= ( i= ( irr-- ee II ) / ( 1 + e) / ( 1 + e II ))

Real dollar analysis ( R$ )Real dollar analysis ( R$ )

iiCRCR= ( i= ( irr-- ee II ) / ( 1 + e) / ( 1 + e II ))


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MARKET INTEREST RATE RATE OF RETURNMARKET INTEREST RATE RATE OF RETURNRELATIVE TO U.S. DOLLARSRELATIVE TO U.S. DOLLARS

MARKET INTEREST RATE RATE OF RETURNMARKET INTEREST RATE RATE OF RETURNRELATIVE TO U.S. DOLLARSRELATIVE TO U.S. DOLLARS

ii f cf c = i= i USUS+ f+ f ee+ f+ f ee( i( i USUS))

ii USUS= ( i= ( i f cf c -- ff ee) / ( 1 + f) / ( 1 + f ee))

ii USUS= market (combined ) interest rate of= market (combined ) interest rate ofreturn relative to US dollarsreturn relative to US dollars

ii f cf c = i= i USUS+ f+ f ee+ f+ f ee( i( i USUS))

ii USUS= ( i= ( i f cf c -- ff ee) / ( 1 + f) / ( 1 + f ee))

ii USUS= market (combined ) interest rate of= market (combined ) interest rate ofreturn relative to US dollarsreturn relative to US dollars

ii f cf c = market (combined ) interest rate of return= market (combined ) interest rate of returnrelative to foreign country currencyrelative to foreign country currency

ffee= Annual rate of change in exchange rate= Annual rate of change in exchange rate ----annual devaluation rateannual devaluation rate ---- between foreignbetween foreigncountry currency and US dollarcountry currency and US dollar

ffee +: foreign currency devalued relative to dollar+: foreign currency devalued relative to dollar

ffee-- : dollar devalued relative to foreign currency: dollar devalued relative to foreign currency

ii f cf c = market (combined ) interest rate of return= market (combined ) interest rate of returnrelative to foreign country currencyrelative to foreign country currency

ffee= Annual rate of change in exchange rate= Annual rate of change in exchange rate ----annual devaluation rateannual devaluation rate ---- between foreignbetween foreigncountry currency and US dollarcountry currency and US dollar

ffee +: foreign currency devalued relative to dollar+: foreign currency devalued relative to dollar

ffee-- : dollar devalued relative to foreign currency: dollar devalued relative to foreign currency

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