Module 10: Inflation

SI-4151 Ekonomi Teknik

Outline Module 10
 Inflation
 Inflation Rate
 Present Worth Calculation
 Cost Estimation

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Inflation
 The prices for goods and services are driven upward or downward
because the effect of factors in economy.
 Inflation is term related to the change in price level in economy,
at which the amount of goods and/or services purchased is
reduced for the same amount of money spent.
 Deflation is the term for opposite condition
 Price Index is a ratio used to measure the historical price-level
changes for a particular commodities or general cost of living (e.g.,
Consumer Price Index (CPI)
CPI

300

200

100 Year
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Definitions
 Inflation rate (f)
the annual percentage of increase in prices of goods or services

 Inflation-free interest rate (i)

represents the earning power if money with the effect of inflation removed

 Inflated interest rate (if)

represents the rate of interest (earning power of money) with inflation considered; it is also
called market interest rate or inflation adjusted interest rate.
i f  i  f  if
Inflated interest,

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Inflation Rate
 The rate of inflation (+f) (or deflation (-f)) is calculated based on changes in prices in successive
years. This rate has a compounding effect.

 Annual inflation rate for year (t+1)

CPI t 1  CPI t 

f 
CPI  t 
Future’s Dollars
$ t 2  (then-current dollars)
 Dollars in period t1 $t1 
 (Constant-value Dollars, or Today’s Dollars) Inflation t1t 2

$ t 2 
$t 1 
 Today’s dollar
1  f  n
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Present Worth Calculation using Inflated Rate
 An item that cost $ 5,000 today is subjected
to 4% rate of inflation and 10% of interest
 Inflated interest rate, if = i + f + if = 0.1 +
0.04 + 0.1*0.04 = 0.144 (14.4%)

(1) (2) (3) (4) = (3)(P/F, if,

EOY Future cost in (P/F.14.4%,n) n)
then dollars Present worth
0 5000 1 5000
1 5200 0.8741 4545
2 5408 0.7641 4132
3 5624 0.6679 3757
4 5849 0.5838 3415

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Example#1
 A former student of an engineering department
wishes to donate the department’s scholarship fund.
Three options are available:
 Plan A $60,000 now
 Plan B $15,000 per year for 8 years beginning 1 year from
now
 Plan C $50,000 three years from now and another $80,000,
five years from now
From the department’s perspective it wants to select the plan
that maximizes the buying power of the dollars received. The
department head asked the engineering professor evaluating
the plans to account for inflation in the calculations.
If the donation earns a real 10% per year and the inflation rate
is expected to average 3% per year, which plan should be
accepted?

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Example
 if = 0.10 + 0.03 + 0.10(0.03) = 0.133
 PWA=$60,000
 PWB=$15,000(P/A,13.3%,8)=$15,000(4.7508)
=71,262
 PWC=$50,000(P/F,13.3%,3)+
$80,000(P/F,13.3%,5)
=$50,000(0.68756)+
$80,000(0.53561)=77,227

 Since PWC is the largest in today’s dollars,

select plan C.
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Example#2
 What annual deposit is required for 5 years to
accumulate an amount of money with the same
purchasing power as $680.58 today, if the market
interest rate is 10% per year and inflation is 8% per year?
Answer:
The actual number of future (inflated) dollars required 5 years
from now:
F = (present buying power)(1+f) 5 = 680.58(1.08)5 = 1000

The actual amount of the annual deposit is calculated using

the market (inflated) interest rate 10%:
A = 1000(A/F,10%,5) = $163.80

9 SI-4151 Ekonomi Teknik

Comment
(case without considering inflation)
The real interest rate, i = 1.85% as determined using if = i + f +
if
If the inflation rate is 0, when the real interest rate is 1.85%,
the future amount of money with the same purchasing power
as $680.58 today is obviously $680.58.
Then the annual amount required to accumulate this future
amount in 5 years is A = 680.58(A/F,1.85%,5) = $131.17.

This is $32.63 lower than the $163.80 calculated for f =8%.

This difference is due to the fact that during inflationary
periods, dollars deposited have more buying power than the
dollars returned at the end of the period.  the value of
money has decreased
To maintain equivalent purchasing power at f=8% per year, an
extra $32.63 per year is required.

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Cost Estimation
 Cost at any point in time can be estimated using comparison of cost at any other
time
 Cost Index is a ratio of the cost of an itemI today to the cost at some point in time
Ct  C0 t
I0
Ct = estimated cost at present time t
C0 = cost at base time t0
It = index value at time t
I0 = index value at time t0

 Cost Capacity Factor is a ratio of a certain volume to the other volume

x
Q 
C2 = estimated cost at capacity Q2
C2  C1  2 
C1 = cost at capacity Q1
 Q1 
Q1 = capacity 1
Q2 = capacity 2
x = capacity factor, exponent, varies depending type of product

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Homework
1. An investor is considering to build a new oil refinery plant
with the capacity of 800,000 barrel per day (bpd). 15
years ago a similar plant with a capacity of 700,000 bpd
was built for US$ 575 million. If the inflation is estimated
at 4% annually, what is the estimated cost for building the
new plant? Cost capacity factor for oil refinery is 0.64
2. An item is bought for Rp 7,5 million five years ago when
the consumer price index is recorded at 112 point. Today,
when the index is calculated at 119, what is the estimated
cost of the same item?
3. What will be the value of a bulldozer cost index in 2010 if it
was 276.5 in 2003, when it increases 6% a year?

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