Meaning and Measure of Inflation
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Transcript Meaning and Measure of Inflation
Lecture No. 35
Chapter 11
Contemporary Engineering Economics
Copyright © 2010
Contemporary Engineering Economics, 5th edition, © 2010
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.
College Cost Calculator
Contemporary Engineering Economics, 5th edition, © 2010
Inflation and Economic Analysis
What is inflation?
How do we measure inflation?
How do we incorporate the effect of inflation in
equivalence calculation?
Contemporary Engineering Economics, 5th edition, © 2010
What is Inflation?
Time Value of Money
Definition: Inflation is
Earning Power
the rate at which the
Purchasing Power
general level of prices
and goods and services is Earning Power
rising, and subsequently,
Investment Opportunity
purchasing power is
falling.
Purchasing Power
Decrease in purchasing power (inflation)
Increase in purchasing power (deflation)
Contemporary Engineering Economics, 5th edition, © 2010
Inflation - Decrease in Purchasing Power
$100
$100
1990
1990
You could buy 50 Big Macs
in year 1990 with $100
$2.00 / unit
2010
You can only buy 28.5 Big
Macs in year 2010.
75%
Price change
due to
inflation
$3.50 / unit
The $100 in year 2010 has only $57
worth purchasing power of 1990
Contemporary Engineering Economics, 5th edition, © 2010
Deflation - Increase in Purchasing Power
$100
2004
2005
$100
2006
2010
You could purchase
63.69 gallons of purified
drink water a year ago.
$1.57 / gallon
2004
2005
2006
2010
You can now purchase
80 gallons of purified
drink water.
20.38%
$1.25 / gallon
Price change due to
deflation
Contemporary Engineering Economics, 5th edition, © 2010
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 average 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.
Contemporary Engineering Economics, 5th edition, © 2010
Consumer Price Index
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.
CPI (Old measure) – Base Period = 1967
1967
100
2010
649.10 (January)
CPI (New measure) – Base Period
(1982-84)
1982-84
2010
100
216.68 (January)
Contemporary Engineering Economics, 5th edition, © 2010
Selected Price Indexes (Index for Base Year = 100,
Calendar Month = April)
Contemporary Engineering Economics, 5th edition, © 2010
Average Inflation Rate (f )
Fact:
Base Price = $100 (year 0)
Step 1: Find the actual inflated price at the end
of year 2.
Inflation rate (year 1) = 4%
Inflation rate (year 2) = 8%
Find: Average inflation rate over
2 years?
$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)2 = $112.32
f = 5.98%
0
$112.32
1
2
$100
Contemporary Engineering Economics, 5th edition, © 2010
Example 11.1 Average Inflation Rate
Sample Calculation for
Average Inflation rate for
Gasoline:
Average Inflation Rate
Given: P = 127.3, F =
175.3, N = 2009-2000 = 9.
Find: f
Contemporary Engineering Economics, 5th edition, © 2010
General Inflation Rate (f)
Formula:
Calculation:
Given:
_
CPIn CPI0 (1 f )n ,
1/ n
CPI
f n 1
CPI0
_
CPI for 2009 = 213.2,
_
where
f The genreal inflation rate,
where
CPI The consumer price index at the end period n,
Theconsumer
consumer price
index
for theatbase
CPICPI=0 The
price
index
theperiod.
end
n
general inflation rate
f = The
n
of period n,
CPI0 = The consumer price index for the
base period.
CPI for 2000 = 172.2
Find: f
213.2
f
172.2
2.40%
Contemporary Engineering Economics, 5th edition, © 2010
1/9
1
Example 11.2 Yearly and Average Inflation Rates
Year
cost data:
Year
Cost
0
$504,000
1
538,000
2
577,000
3
629,500
Solution:
Find: Yearly and Average
inflation rates
Contemporary Engineering Economics, 5th edition, © 2010
Inflation Terminology – II
Actual Dollars (An ): Estimates of future cash
flows for year n that take into account any
anticipated future 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).
Contemporary Engineering Economics, 5th edition, © 2010
Finding Actual Dollars
Conversion from Constant to Actual
Dollars
General inflation rate = 5%
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
Contemporary Engineering Economics, 5th edition, © 2010
Finding Constant Dollars
Conversion from Actual to Constant
dollars
Example 11.4 - General inflation
rate of 5%
End of
period
Cash Flow in
Actual $
Conversion
at f = 5%
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
Contemporary Engineering Economics, 5th edition, © 2010
Cash Flow in
Constant $
Loss in
Purchasing
Power