Chapter 4

Measure of Inflation
Mechanical Engineering Department
College of Engineering
Al Imam Mohammad Ibn Saud Islamic
University

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Inflation and Economic Analysis

 What is inflation?
 How do we measure inflation?
 How do we incorporate the effect of
inflation in equivalence calculation?

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INFLATION: An Enemy of Economic Growth

“Inflation is taxation (‫ )فرض الضرائب‬without legislation

(‫)تشريع‬.”
Milton Friedman

Al Imam Muhammad Ibn Saud

Islamic University 3
 What is Inflation?
A loss in the purchasing power of money over time. Inflation
means that the cost of an item tends to increase over time, or
the same dollar amount buys less of an item over time.

Value of Money
Earning Power How much you currently make at your place of
employment plays a major part in your earning power.
Purchasing power The value of a currency expressed in terms
of the amount of goods or services that one unit of money can buy.

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

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 Purchasing Power

$100 $ 80

2010 2010 2015

You could buy 50 chocolate You can only buy 40

year 2010. chocolate in year 2015.

25%
$ 2.0 / unit % 2.5 / unit
Price change
due to
inflation

The $ 100 in year 2010 has only $ 80

Worth purchasing power of year 2015

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 $100 $100

-2 -1 0 1 -2 -1 0 1

You could purchase 63.69 You can now purchase 80

gallons of unleaded gas gallons of unleaded gas.
a year ago.

20.38%
$1.57 / gallon $1.25 / gallon
Price change due to
deflation

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 Inflation Terminology - I
 Consumer Price Index (CPI): 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 city consumers

 Producer Price Index (PPI): a statistical measure of

wholesale industrial price change, compiled monthly by the BLS (Bureau
of Labor Statistics) to evaluate wholesale price levels in the economy. Its
components are broken down by industry sector, product.

 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.

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 Measuring Inflation
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) 2002
$100 $178.9
CPI for 2002 = 178.9

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Selected Price Indexes
Year New CPI Old CPI Gasoline Steel Automobile
(Base Period) (1982-84) (1967) (1982) (1982) (1982)

2002 178.9 535.8 89.0 114.1 134.9

2003 183.8 550.5 100.1 121.5 135.1
2004 188.0 563.2 126.1 162.4 136.5
2005 194.6 582.9 162.4 171.1 135.1
2006 201.5 600.9 217.7 186.6 130.6
2007 206.7 619.1 232.7 193.4 136.6
2008 214.8 643.5 294.3 207.4 135.2
2009 213.2 653.1 177.3 156.5 134.9
2010 218.0 303.6 244.8 195.8 138.2
2011 223.5 669.4 303.6 216.0 140.9

Source U.S. Bureau of Labor Statistics

We can calculate the price index( or inflation rate of gasoline

from 2010 to 2011 as follows:
(303.6-244.8)/ 244.8 = 24.02%

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Consumer Price Index: Case Study
Saudi Arabia Consumer Price Index (CPI)
Consumer Price Index CPI in Saudi Arabia increased to 132.20
Index Points in May of 2015 from 132 Index Points in April of
2015. Consumer Price Index CPI in Saudi Arabia averaged
100.86 Index Points from 1999 until 2015, reaching an all time
high of 132.20 Index Points in May of 2015 and a record low of
84.80 Index Points in August of 2001. Consumer Price Index
CPI in Saudi Arabia is reported by the Central Department of
Statistics & Information, Saudi Arabia.

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Islamic University 10
Consumer Price Index: Case Study

China Consumer Price Index (CPI) 1986-2015

Consumer Price Index CPI in China decreased to 101.20 Index
Points in May of 2015 from 101.50 Index Points in April of 2015.
Consumer Price Index CPI in China averaged 105.60 Index
Points from 1986 until 2015, reaching an all time high of 128.40
Index Points in February of 1989 and a record low of 97.80 Index
Points in April of 1999. Consumer Price Index CPI in China is
reported by the National Bureau of Statistics of China.

Additional information can

[Link]
been seen here
Al Imam Muhammad Ibn Saud
Islamic University 11
Consumer Price Index: Case Study

Al Imam Muhammad Ibn Saud

Islamic University 12
13
Consumer Price Index: Case Study
Prices for food items and construction materials

Food Items Construction

materials

Prices are quite stable (‫ )مستقر‬for food items and

construction materials, so the inflation rate is less

Source: Center Department of Statistics and Information, Kingdom of Saudi Arabia

[Link]
&Itemid=113

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Islamic University 14
 Average Inflation Rate
Example 4.1: Consider the price increases for the following items over the last 11 years.

Items 2000 Price ($) 2011 Price ($) AIR (%)

Postage 0.33 0.44 2.65

Auto insurance (per year) 687 872 2.19

Private college tuition and fees 15,518 27,293 5.27

Gasoline (per gallon) 1.56 3.64 8.01

Car (Toyota Camry) 21,000 22,590 0.67

Natural gas (per million BTUs) 3.17 11.99 12.86

Consumer Price Index

Base Period: 1982-84 = 100 171.20 223.47 2.45

Explain how the average inflation rates are calculated for each of the items given in the
table
Al Imam Muhammad Ibn Saud
Islamic University 15
 Average Inflation Rate (f )
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 $112.32

following equivalence equation.

0 1
2
$100 ( 1+ f ) = $112.32 2
f = 5.98%
$100
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General Inflation Rate ( f )
Average inflation rate based on the CPI
_
CPIn  CPI0 (1 f )n ,
_
CPIn 1/n
f  1
CPI0
_
where f  The genreal inflation rate,
CPIn  The consumer price index at the end period n,
CPI0  The consumer price index for the base period.

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Example 4.1: Yearly and Average Inflation Rates

Year Cost What are the annual inflation rates

0 $504,000 and the average inflation rate over 3 years?
1 538,000
2 577,000
3 629,500 Solution
Inflation 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
$629,500 1/ 3
f ( )  1  0.0769  7.69%
$504,000
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 General Inflation Rate
Example 4.2: The table below shows the average cost since 2005 for a family of four to
attend a Boston Sox game. Determine the specific inflation rate for each period, and
calculate the average inflation rate over the six years? CPI for base period1982-1984 is
96.5.

Yearly inflation rate

Year Cost ($)
(%)
2005 276.24
2006 287.84 4.20
2007 313.83 9.03
2008 320.71 2.19
2009 326.45 1.79
2010 334.78 2.55
2011 339.01 1.26

Al Imam Muhammad Ibn Saud

Islamic University 19
20
 Inflation Terminology – II
The effect of inflation into economic analysis

 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. Usually, these
amounts are determined by applying an inflation rate to
base-year dollar estimates.

 Constant (real) Dollars (A'n):

Represents constant purchasing power independent of
the passage of time. We will assume that the base year
is always time zero unless we specify otherwise.

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 Conversion
from Constant to Actual Dollars
_ _
An  A' n (1  f )  A' n ( F / P, f , n)
n

n  3 $1,260
$1,000
_
f  8%

3
3
Actual
Constant
3 Dollars
Dollars $1,000 (1 + 0.08)
= $1,260

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 Example 4.2 Conversion from
Constant to Actual Dollars
Period Net Cash Flow in Conversion Cash Flow in
Constant $ Factor 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

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 $120,000 $130,000
$110,000
$100,000 $120,000

0
1 2 3 4 5
Years

$130,000(1+0.05)4

$120,000(1+0.05)5
(a) Constant dollars

$100,000(1+0.05)

$120,000(1+0.05)3
$110,000(1+0.05)2
$250,000
$250,000(1+0.05)0

$138,915 $158,016
$121,275
$105,000 $153,154

0
1 2 3 4 5
Years
(b) Actual dollars
$250,000
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 Conversion from
Actual to Constant Dollars

n  3 $1,260
$1,000
_
f  8%

3
3
Actual
Constant -3
$1,260 (1 + 0.08) Dollars
Dollars
= $1,000

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 Example 4.3 Conversion from
Actual to Constant Dollars
End of Cash Flow in Conversion Cash Flow in Loss in
period Actual $ at f = 5% Constant $ 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

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4.2 The average cost of a gallon of gas was $0.80 per gallon in 1995. In 2011,
the average cost of a gallon of gas is $3.50. What is the average inflation rate
for the period 1995-2011?

4.6 Because of general price inflation in our economy, the purchasing power of
the dollar shrinks with the passage of time. If the average general inflation rate
is expected to be 8% per year for the foreseeable future, how many years will it
take for the dollar's purchasing power to be one-third of what it is now?

4.7 An engineer's salary was $40,000 in 2004. The same engineer's salary in
2012 is $75,000. If the company's salary policy dictates that a yearly raise in
salaries reflect the cost of living increase due to inflation, what is the average
inflation rate for the period 2004-2012?

4.8 The average starting salary for engineers was $8,000 a year in 1985. John,
a mechanical engineer, got an offer for $48,000 a year in 2012. Knowing that
the CPIs for 1985 and 2012 are 36.87 and 205.43, respectively, what is John's
real salary in terms of constant 1985 dollars?

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Equivalence Calculation Under Inflation
1. Types of Interest Rate
Market Interest rate (i)
Inflation-free interest rate (i')
2. Types of Cash Flow
In Constant Dollars
In Actual Dollars
3. Types of Analysis Method
Constant Dollar Analysis
Actual Dollar Analysis
Deflation Method
Adjusted-discount method

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 Inflation Terminology - III
 Inflation-free Interest Rate ( i' ): an estimate of the
true earning power of money when the inflation
effects have been removed (also known as real
interest rate).
 Market interest rate ( i ): commonly known as the
nominal interest rate, which takes into account the
combined effects of the earning value of capital
(earning power) and any anticipated inflation or
deflation (purchasing power). Most firms use a
market interest rate (also known as inflation-adjusted
required rate of return) in evaluating their investment
projects.

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30
Inflation and Cash Flow Analysis
Constant Dollar analysis (inflation free interest rate i' )
• Estimate all future cash flows in constant dollars.
• Use i' as an interest rate to find equivalent worth.

Actual Dollar Analysis ( market interest rate i )

• Estimate all future cash flows in actual dollars.
• Use i as an interest rate to find equivalent worth.

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Constant Dollar (A'n ) Analysis

 In the absence of inflation, all economic analyses up

to this point is, in fact, constant dollar analysis.

 Constant dollar analysis is common in the evaluation

of many long-term public projects, because
government do no pay income taxes.

 For private sector, income taxes are charged based

on taxable income in actual dollars, actual dollar
analysis is more common.

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Constant Dollars (An ) Analysis

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Actual Dollars (An ) Analysis

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Actual Dollars (An ) Analysis

 Method 1: Deflation Method

Step 1: Bring all cash flows to have

common purchasing power
(constant dollars).
Step 2: Consider the earning
power(Present Worth).

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Example 4.4: Step 1: Convert actual dollars
to Constant dollars

n Cash Flows in Actual Multiplied by Cash Flows in

Dollars Deflation Constant Dollars
Factor

0 -$75,000 1 -$75,000
1 32,000 (1+0.05)-1 30,476

2 35,700 (1+0.05)-2 32,381

3 32,800 (1+0.05)-3 28,334

4 29,000 (1+0.05)-4 23,858

5 58,000 (1+0.05)-5 45,445

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Step 2: Convert Constant dollars to
Equivalent Present Worth
n Cash Flows in Multiplied by Equivalent
Constant Dollars Discounting Present Worth
Factor
0 -$75,000 1 -$75,000
1 30,476 (1+0.10)-1 27,706

2 32,381 (1+0.10)-2 26,761

3 28,334 (1+0.10)-3 21,288

4 23,858 (1+0.10)-4 16,295
5 45,445 (1+0.10)-5 28,218

$45,268

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 Deflation Method (Example 4.6):
Converting actual dollars to constant dollars and then
to equivalent present worth
n=0 n=1 n=2 n=3 n=4 n=5

Actual
Dollars -$75,000 $32,000 $35,700 $32,800 $29,000 $58,000

Constant -$75,000 $30,476 $32,381 $28,334 $23,858 $45,455

Dollars

Present
-$75,000
Worth
$27,706 $26,761 $21,288 $16,295 $28,218

$45,268

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Adjusted-Discount Method
 Method 2: Adjusted-discount
Method
Combine Steps 1 and 2 into one step.
An
Pn 
(1  i ) n
An An

(1  i ) n
(1  f )(1  i ') 
n

 
(1  i )  (1  i )(1  i ')
 1  i ' f  i ' f

i  i ' f  i ' f
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Example 4.7 Adjusted-Discounted Method
i  i '  f  i' f
 0 .1 0  0 . 0 5  ( 0 .1 0 )( 0 . 0 5 )
 15 . 5%

n Cash Flows in Actual Multiplied Equivalent

Dollars by Present Worth
0 -$75,000 1 -$75,000
1 32,000 (1+0.155)-1 27,706
2 35,700 (1+0.155)-2 26,761
3 32,800 (1+0.155)-3 21,288
4 29,000 (1+0.155)-4 16,296
5 58,000 (1+0.155)-5 28,217
$45,268

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4.1 The average unleaded-gasoline price for residents of a city on May 30, 2011, was
$5.20 per gallon. Assuming that the base period (price index=100) is 1996 and that the
unleaded-gasoline price for that year was $2.10 per gallon, compute the average price
index for the unleaded-gasoline price for the year 2011.
4.2 The average cost of a gallon of gas was $0.80 per gallon in 1995. In 2011, the average
cost of a gallon of gas is $3.50. What is the average inflation rate for the period 1995-
2011?
4.6 Because of general price inflation in our economy, the purchasing power of the dollar
shrinks with the passage of time. If the average general inflation rate is expected to be 8%
per year for the foreseeable future, how many years will it take for the dollar's purchasing
power to be one-third of what it is now?
4.7 An engineer's salary was $40,000 in 2004. The same engineer's salary in 2012 is
$75,000. If the company's salary policy dictates that a yearly raise in salaries reflect the cost
of Jiving increase due to inflation, what is the average inflation rate for the period 2004-
2012?
4.8 The average starting salary for engineers was $8,000 a year in 1985. John, a
mechanical engineer, got an offer for $48,000 a year in 2012. Knowing that the CPis for
1985 and 2012 are 36.87 and 205.43, respectively, what is John's real salary in terms of
constant 1985 dollars?
4.9 If you are looking for a 4% real return (inflation-free interest) on your investment, would
you be interested in an investment opportunity that produce a 9% return on investment
(market interest rate) if the inflation rate is 5%?

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4.13 Given the cash flows in actual dollars provided in the following table, convert
the cash flows to equivalent cash flows in constant dollars if the base year is time
0. Assume that the market interest rate is 16% and that the general inflation rate(/)
is estimated at 4% per year.
n Cash Flow (in Actual $)
0 $ 20,500
4 $ 41,500
5 $ 36,500
7 $ 55,500

PP= The annual fuel costs to generate electricity for a power plant outside
Riyadh are projected to be 1,950,000 SR, without consideration for any future
inflation. The annual inflation free interest rate will be 7% and general inflation
rate is 4%. If the plant has a remaining useful life of six years. Determine:
a. Equivalent Present value of its fuel cost, using actual-dollar and constant
dollar analysis?
b. Compute the difference between the two analysis?

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4.17 A 10-year $2,000 bond pays a nominal rate of 8% compounded
semiannually. If the market interest rate is 9% compounded annually and the
general inflation rate is 5% per year, find the actual and constant dollar amount
(time= year zero dollars) of the 14th interest payment on the bond.

4.20 You just signed a business consulting contract with one of your clients. The
client will pay you $80.000 a year for five years for the service you will provide
over this period. You anticipate the general inflation rate over this period to be
5%. If your desired inflation-free interest rate (real interest rate) is to be 3%,
what is the worth of the fifth payment in present dollars? The client will pay the
consulting fee at the end of each year.

4.21 Suppose that you borrow $60,000 at 9% compounded monthly over five
years. Knowing that the 9% represents the market interest rate. you compute
the monthly payment in actual dollars as $1,245.5 1. If the average monthly
general inflation rate is expected to be 0.25%, determine the equivalent equal
monthly payment series in constant dollars.

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4.22 The annual fuel costs to operate a small solid-waste treatment plant are projected lo be
$1.8 million. without consideration for any future inflation. The best estimates indicate that the
annual inflation-free interest rate (i ') will be 7% and the general inflation rate = 4%. If the
plant has a remaining useful life of five years. what is the present equivalent value of its fuel
costs. using actual-dollar analysis?

4.23 Suppose that you just purchased a used car worth $14.000 in today's dollars. Assume
also that, to finance the purchase, you borrowed $12,000 from a local bank at 8%
compounded monthly over two years. The bank calculated your monthly payment at $542.36.
Assume that average monthly general inflation will run at 0.1% over the next two years.
(a ) Determine the annual inflation-free interest rate (i') for the bank.
(b) What equal monthly payments, in terms of constant dollars over the next two years, are
equivalent to the series of actual payments to be made over the life of the loan?

4.26 A couple wants to save for their daughter's college expense. The daughter will
enter college eight years from now, and she will need $50,000, $51,000, $52,000,
and $53,000 in actual dollars for four school years. Assume that these college
payments will be made at the beginning of each school year. The future general
inflation rate is estimated to be 7% per year, and the annual inflation-free interest rate is 6%.
(a) What is the market interest rate to use in the analysis?
(b) What is the equal amount, in actual dollars, the couple must save each year
until their daughter goes to college?

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53
 Summary
 The Consumer Price Index (CPI) is 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.
 Inflation is the term used to describe a decline in
purchasing power evidenced in an economic
environment of rising prices.
 Deflation is the opposite: An increase in
purchasing power evidenced by falling prices.
 Base Period is the point in the past with which
current prices are compared.
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