Transcript Chapter 9: Inflation - University of Waterloo

INFLATION
• Prices of all goods and services change
over time
• An increase in average prices over time is
called inflation
• A decrease in average prices over time is
called deflation
• Prices are likely to change over the life of
an engineering project due to inflation or
deflation
JK Higginson: Engineering
Economics
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NOMINAL AND REAL
DOLLARS
Nominal Dollars: dollars at the time that
cash flows occur
• These are the ones in our pockets, and
recorded in our bank books, cheque
books, accounting records
• The purchasing power of these changes
due to inflation/deflation
• Also as known as current or actual dollars
Real Dollars: dollars of constant purchasing
power
• These are a hypothetical unit of measure
• Always need a reference date (usually
called the “base year”)
• The base year need not be the current
year
• Also as known as constant dollars
JK Higginson: Engineering
Economics
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USES OF PRICE INDICES IN
ENGINEERING PROJECTS
•
•
Contract Escalation
– A mining company entering a long-term
equipment purchase contract with a major
distributor wants to establish guidelines which
will govern the future prices of the equipment it
buys.
– Using the Mining, Quarrying and Ore dressing
Machinery Index, the company ties the future
price increases of equipment to those of the
index.
Tracking Selling Prices
– A pharmaceutical firm wants to compare price
changes for its products with those of the
industry as a whole.
– Using a series of Pharmaceutical Indexes,
analysts can compare their price trends over
time with those of the industry. In this way, they
can get a sense of their own competitiveness.
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Economics
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CONVERSION BETWEEN
ACTUAL AND REAL
DOLLARS
If we have an estimate of the inflation rate
per period over N periods, we can
convert actual dollars in period N to
real dollars.
AN = actual dollars in year N
R0,N = real dollars equivalent to AN
relative to year 0 (the base year)
f = the inflation rate per year (assumed
to be constant from year 0 to year N)
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Economics
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Then the conversion from actual dollars in
year N to real dollars in year N relative to
the base year 0 is:
R0,N 
AN
(1  f )N
The base year (0) is usually omitted from the
notation:
RN 
AN
(1  f )N
This can conveniently be written and
computed with the Present Worth Factor:
RN = AN(P/F, f, N)
RN is real dollars at time N and not a present
worth
JK Higginson: Engineering
Economics
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NOMINAL AND REAL INTEREST
RATES
The real interest rate, i’, is the interest
rate that would yield the same number
of real dollars in the absence of
inflation as the actual interest rate
yields in the presence of inflation.
 1 i 
M(1  i' )  M

 1 f 
From nominal to real:
1 i
i' 
1
1 f
From real to actual:
i = i’ + f + i’f
JK Higginson: Engineering
Economics
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ACTUAL AND REAL
MARRS
If investors expect inflation, they will
require higher actual rates of return on
their investments than if no inflation
was expected.
MARRactual = MARRreal + f + MARRreal f
1  MARR actual
MARR real 
1
1 f
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Economics
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ECONOMIC EVALUATION
WITH INFLATION
Method 1: Work with real cash
flows and find the real MARR
using an estimate of f.
Method 2: Adjust the real cash
flows for inflation; ie., get
estimates of the actual cash
flows using f, and apply the
actual MARR.
JK Higginson: Engineering
Economics
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