DEALING WITH INFLATION
AND PRICE CHANGES
INTRODUCTION
General Price Inflation – an increase in the
prices paid for goods and services
bringing about a reduction in the
purchasing power of the monetary unit
- a reality than can affect the economic
comparison of alternatives.
- more common than deflation
Consumer Price Index (CPI)
- a composite price index that measures
price changes in housing, transportation,
clothing, food, and other selected goods
and services used by individuals, and
families.
(CPI annual (CPI ) k (CPI ) k 1
100
inflation rate)k (CPI ) k 1
CPI along with other indexes such as
Producer Price Index and Implicit Price
Index for the GNP are based on
historical data and for short-term
forecasting.
Long-term forecasts of price changes
may be purchased of providing
forecasting services.
TECHNOLOGY AND BASIC CONCEPTS
1) ACTUAL PRICES (A) – the amount of
money associated with a cash flow (or a
non-cash flow amount such as
depreciation) as of the time it occurs.
2) REAL PRICES (R) – money expressed
in terms of the same purchasing power
relative to a particular time.
3) GENERAL PRICE INFLATION RATE
(f) – a measure of the change in the
purchasing power of money during a
specified period of time.
4) COMBINED (NOMINAL) INTEREST
RATE ( ic) – the money paid for the use
of capital, expressed as an effective rate
(%) per interest period, that includes a
market adjustment for the anticipated
general price inflation rate in the
economy.
5) REAL INTEREST RATE (ir) – does not
include a market adjustment for the
anticipated general price inflation rate in
the economy (inflation free interest rate)
6) BASE TIME PERIOD (b) – the
reference or base time period used to
define the purchasing power of real
(constant) dollars.
RELATIONSHIP BETWEEN ACTUAL
PRICES AND REAL PRICES
defined in terms of the general price
inflation rate {a function of f}
In general,
k b
1
R k Ak
1 f
Rk = Ak (P/F, f %, k – b)
For a specific cash flow j,
Rk,j = Ak,j (P/F, f %, k – b)
At the base period,
Rk,j = Ak,j
Ex. Salary is incremented 6% and the average
inflation rate is 8%/yr.
Year, k Salary (AP) (RP)
b=1 P 35000 P 35000
2 37100 34351
3 39326 33714
4 41685 33090
Year CPI Inflation Rate
1978 100.0 -
1979 117.5 17.5 %
1980 138.9 18.2 %
1981 157.1 13.1 %
1982 173.2 10.2 %
1983 190.5 9.9 %
1984 286.4 50.3 %
1985 352.6 23.1 %
1986 355.3 0.8 %
1987 368.7 3.8 %
1988 401.0 8.8 %
1989 413.6 3.1 %
1990 425.2 2.8 %
**For projects, inflation rate is projected/assumed as a
constant.
What interest rates to use in eng’g economy
studies?
Method If cash flows are in Then the interest
terms of: rate to use is:
A Actual Prices (A) ic
B Real Prices (R) ir
Economic analysis using either actual or
real dollars provide that the appropriate
interest rate is used, will yield the same
results.
- consistency is important!
MISTAKES
1: ic and R – Bias against capital investment
2: ir and A – Bias towards capital investment
(1) The cash flow estimates in real prices for a
project are numerically lower in value than
actual dollar estimates with equivalent
purchasing power (assuming that f > 0)
- the ic (>ir) further reduces the equivalent
worth of the results of a proposed capital
investment.
Relationship among the combined and
Real Interest Rates and the General
Inflation Rate
1
( EW )b Ak
(1 i c ) k b
1
Rk Ak k b
Ak ( P / F , f %, k b)
(1 f )
1 1 1
(EW)b Rk k b
Ak
kb kb
(1 ir ) (1 f ) (1 ir )
1 1 1
Ak k b
Ak
k b k b
(1 ic ) (1 f ) (1 i r )
(1 + ic)k-b = (1 + f)k-b (1 + ir)k-b
1 + ir = (1 + f) (1 + ir)
Eq.1 : ic = ir + f + ir f
Eq.2 :
ic f
ir
1 f
Fixed and Responsive Annuities
- Included in engineering economy studies
are certain quantities unresponsive to
general price inflation, such as
depreciation, or lease fees and interest
charges based on an existing contract or
loan agreement.
- It is important to recognize the quantities
that are unresponsive to general price
inflation.when doing real price
analysis, convert these actual quantities
to real quantities.
The Impact of General Price Inflation
on After Tax Analysis.
Undertake ATCF Analysis using actual
prices since there are quantities w/c are
unresponsive to inflation.
VARIATION IN THE GENERAL PRICE
INFLATION RATE
- In the case where the estimated annual
rates vary during the analysis period,
these varying rates would be applied
successively to the costs and revenues
for the years involved.
Apply:
k
1 f l for b 0
l 1
- for R to A
- Reverse for A to R!
CALCULATING AN EFFECTIVE GENERAL
PRICE INFLATION RATE
1
N
N
f 1 f k 1
k 1