BIE 420

ENGINEERING
ECONOMICS
Study Unit 3: Inflation in Economic Analysis
 • Meaning

Notes •
•
Causes
Measures
• Inflation and Interest
Index •
•
Actual Rands vs Constant Rands
Inflation and Equivalence
Meaning
3.1. Meaning
■ Inflation is defined as a sustained increase in the general level
of prices for goods and services in a country, and is measured
as an annual percentage change. Under conditions of
inflation, the prices of things rise over time.
□ Inflation causes money to lose purchasing power (i.e. when
prices inflate less goods or services are purchased with the
same amount of money).
□ Inflation makes future rands less valuable than present Rands.
□ In the context of engineering economic analysis, because
comparisons are made on an equivalent basis, it’s important to
incorporate the effects of inflation in economic analyses.
□ Deflation, a very rare phenomenon in the modern world, has
the opposite effect of inflation.
□ Deflation is when the purchasing power of money increases
(rather than decreases) over time.
■ Economists generally believe that inflation depends on the
following, either in isolation or in combination with one
another: money supply; exchange rates; cost-push;
demand-pull.
3.1. Meaning

Figure 1: An example of a product Figure 2: Some examples of inflating

with inflating prices and deflating prices

Some useful resources:

[Link]
[Link]
Causes
3.2. Causes
■ Money supply
□ The amount of money in any national economy has an effect
on its purchasing power.
□ If there is too much money in the system versus goods and
services to purchase with that money, the value of money
tends to decrease.
□ Money becomes more valuable when its volume in the
economy is limited.
□ Most governments seek to increase the volume of money in the
system at the same rate that the economy is growing.
■ Cost-push
□ This cause of inflation develops as producers of goods and
services “push” their increasing operating costs (such as the
cost associated with fabrication/manufacturing, marketing,
and sales) along to the customer through higher prices.
■ Demand-pull
□ As more and more people demand certain goods and services,
the prices of those goods and services will rise (demand
exceeding supply).
3.2. Causes

■ Exchange rates
□ The strength of currencies in world markets affects the
profitability of international companies.
□ Prices may be adjusted (in certain markets) to compensate for
the relative strength in the world market.
□ As companies’ profits are weakened or eliminated in some
markets owing to fluctuations in the exchange rates, prices
may be raised in other markets to compensate.
Measures
3.3. Measures

■ Price indices describe the relative price fluctuation of goods

and services (i.e. they provide a historical record of prices over
time).
■ Price indices are tracked for specific commodities as well as
bundles (composites) of commodities.
■ As a result, price indices can be used to measure historical
price changes for individual cost items as well as general costs.
■ Past price fluctuations can also be used to predict future
prices.
■ Two price indices are used in South Africa:
□ Consumer Price Index (CPI): The rate of change in the prices
of goods and services purchased by consumers.
□ Producer Price Index (PPI): The rate of change charged by the
producers of goods.
3.3. Measures
3.3. Measures
■ Define chelsea bun index (CBI)
Base year: 2005
Price of a chelsea bun = R4.50 CBI2005 = 100
Year: 2008
Price of a chelsea bun = R4.95

CBI2008 = 4.95 (100) = 110

4.50
Year: 2017
Price of a chelsea bun = R8.50
CBI2017 = 8.50 (100) = 189
4.50
3.3. Measures
■ The relationship between the general (or average) inflation
rate and the CPIs for any two years is

CPIt+n = CPIt (1 + f¯)n (1)

Example 1

The consumer price index (CPI) for chelsea buns is given in the following table

Year CPI
2005 100
2008 110
2017 189

Calculate the general inflation rate for chelsea buns between

(a) 2005 and 2008
(b) 2005 and 2017
3.3. Measures

Example 1 (Solution)

(a) 2005 and 2008

CPI2008 = CPI2005(1 + f¯)3

(b) 2005 and 2017

CPI2017 = CPI2005(1 + f¯)12
Inflation and
Interest
3.4. Inflation and interest
■ The following notations are used to illustrate how inflation
and price change affect interest rates and cash flows:

Inflation rate (f ) Annual percentage increase in

prices of goods and services.
Inflation-free interest rate Measures the “real” growth of
(′ money excluding the effect of in-
flation
Market interest rate (i) Interest rate obtained in the gen-
eral marketplace. It incorporates
both real money growth and infla-
tion.
3.4. Inflation and interest

■ The mathematical relationship between inflation, real and

market interest rates is
(2)
3.4. Inflation and interest
Example 2

Suppose that a professional golfer wants to invest some recent golf winnings in
her hometown bank for one year. Currently, the bank is paying a rate of 5.5%
(per year) compounded annually. Assuming that the inflation rate is expected
to be 2% per year, calculate the inflation-free interest rate.

Example 2 (Solution)
Actual Rands
vs Constant
Rands
3.5. Actual Rands vs Constant Rands

■ Actual Rands
□ The actual out-of-pocket rands received or paid at any point in
time (i.e. it includes the effect of inflation).
■ Constant Rands
□ The hypothetical purchasing power of future receipts and
disbursements based on the purchasing power of rands at some
base year (i.e. it disregards the effect of inflation).
■ Mathematically, the relationship between the two is

(3)
3.5. Actual Rands vs Constant Rands

Example 3

The cash flows below are in actual rands. Convert the cash flows to constant
rands.
3.5. Actual Rands vs Constant Rands
Example 3 (Solution)

1000
= 952
1 + 005
1000
= 898
(1 + 0.05)(1 + 0.06)
1000
Y3 = = 893
(1 + 0.05)(1 + 0.06)(1 + 0.07)
3.5. Actual Rands vs Constant Rands
Inflation and
Equivalence
3.6. Inflation and Equivalence

Example 4

A man wishes to set aside some money for his daughter’s college education.
His goal is to have a bank savings account containing an amount equivalent
to R200,000 in constant dollars at the girl’s 18th birthday. The estimated
inflation rate is 8%. If the bank pays 5% per year compounded annually, what
lump sum should he deposit on the child’s 4th birthday?
3.6. Inflation and Equivalence

′
Example 4 (Solution) - Work in CRD (use i )

F18 = 200000, f = 8%, i = 5%, P4 =?

′ (i − f )
i =
(1 + f )
(0.05 − 0.08)
=
(1 + 0.08)
= −0.0278
i L
1
P4 = F18
(1 + i ′ )n
i L
1
= 200000
(1 − 0.02778)14
= 296696
3.6. Inflation and Equivalence

Example 4 (Alternative Solution) - Work in ARD (use i)

F18 = 200000, f = 8%, 5%, P4 =?

Actual rands = (Constant rands) × (1 + f¯)n

F18(ARD) = F18(CRD)(1 + f )n
= 200000(1 + 0.08)14
= 587438.7249
i L
1
P4 = F18
(1 + i)n
i
1
= 587438.7249
(1 + 0.05)14
= 296697

[The R1 difference is due to rounding errors]

3.6. Inflation and Equivalence

Example 5

The City of Columbia is trying to attract a new manufacturing business. It

has offered to install and operate a water pump plant to provide service to
the proposed plant site. This would cost R50,000 now, plus R5000 per year in
operating costs (starting now) for the next 10 years, all measured in constant
rands.
To reimburse the city, the new business must pay a fixed uniform annual fee,
A, at the end of each year for 10 years. In addition, the business has to pay the
city R50,000 at the end of 10 years (starting at the′ end of year 1). Calculate
the value of A (in actual rands) if it’s given that i’ = 3% f = 7%.
3.6. Inflation and Equivalence

Example 5 (Alternative phrasing)

Convert the cash flow series on the left given in the constant rand domain
(CRD) to the cash flow series on the right in the actual rand domain (ARD),
provided that i ′ = 3% f = 7%.
3.6. Inflation and Equivalence
Example 5 (Solution)

′
f = 7%, i = 3%, A(ARD) =? (Work in ARD)

P(CRD) = 50000 + 5000 + 5000(P/A, 3%, 9)

= 50000 + 5000 + 5000(7.7861)
= 93930.5
′ ′
i = i + f + (i )(f )
= 0.03 + 0.07 + 0.03(0.07)
= 0.1021

P(CRD) = P(ARD)
i L i L
(1 + i)n − 1 1
93930.5 = A(ARD) + 50000
i(1 + i)n (1 + i)n
i 10 − 1 L i L
93930 5 = ( ) (1 + 0.1021) + 50000 1
. A ARD
0.1021(1 + 0.1021)10 (1 + 0.1021)10
∴ A(ARD) = 12319
3.6. Inflation and Equivalence
Example 6

The following cash flows are in the actual rand domain.

Calculate the annual equivalent in the constant rand domain given that i =
11% per year, compounded annually and f = 6%.
3.6. Inflation and Equivalence

Example 6 (Alternative phrasing)

Convert the cash flow series on the left given in the actual rand domain (ARD)
to the cash flow series on the right in the constant rand domain (CRD), provided
that i = 11% f = 6%.
3.6. Inflation and Equivalence
Example 6 (Solution)

A(CRD) =? (Work in CRD)

P(ARD) = 1500(P/A, 11%, 3) + 11500(P/F, 11%, 4)

= 1500(2.4437) + 11500(0.6587)
= 11240.6

′ (i − f )
i =
(1 + f )
(0.11 − 0.06)
=
(1 + 0.06)
= 0.0471

P(ARD) = P(CRD)
i ′ L
(1 + i )n − 1
11240.6 = A(CRD)
i ′ (1 + i ′ )n
i L
(1 + 0.0471)4 − 1
11240.6 = A(CRD)
0.0471(1 + 0.0471)4
∴ A(CRD) = 3149
3.6. Inflation and Equivalence
Example 6 (Alternative Solution) - Cash flows conversion Option

The cash flows in the CRD are

1500
Y1 = = 1415.09
1 + 0.06

1500
Y2 = = 1334.99
(1 + 0.06)2
1500
Y3 = = 1259.43
(1 + 0.06)3
11500
Y4 = = 9109.08
(1 + 0.06)4
3.6. Inflation and Equivalence
Example 6 (Alternative Solution) - Cash flows conversion Option

(i − f )
i′ =
(1 + f )
(0.11 − 0.06)
=
(1 + 0.06)
= 0.0471
i L i L
1 1
P(CRD) = 1415.09 + 1334.99
(1 + 0.0471)1 (1 + 0.0471)2
i L i L
1 1
+ 1259.43 + 9109.08
(1 + 0.0471)3 (1 + 0.0471)4
= 11243.47
i′ ′ L
A(CRD) = P(CRD) i (1 + i )n

(1 + i ′ )n − 1
i L
0.0471(1 + 0.0471)4
= 11243.47
(1 + 0.0471)4 − 1
= 3149