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Contemporary Engineering
Economics, 4th edition, © 2007
Meaning and Measure of Inflation
Lecture No. 43Chapter 11Contemporary Engineering EconomicsCopyright © 2006
Contemporary Engineering
Economics, 4th edition, © 2007
Chapter Opening Story – How Much Will It Cost to Send Your Child to College in Year 2015? A year in college cost
$17,800 in 2005. Due to inflation, the
college expense has been increasing at a rate of 6.5% annually.
Then, in 2015 a year in college would cost about $33,413.
Contemporary Engineering
Economics, 4th edition, © 2007
What is inflation?
How do we measure inflation?
How do we incorporate the effect of inflation in equivalence calculation?
Inflation and Economic Analysis
Contemporary Engineering
Economics, 4th edition, © 2007
Value of Money
Earning Power
Purchasing Power
Earning PowerPurchasing power
Investment Opportunity
Decrease in purchasing power (inflation)Increase in Purchasing Power (deflation)
What is Inflation?Inflation is the rate at which the general level of prices and goods and services is rising, and subsequently, purchasing power is falling.
Contemporary Engineering
Economics, 4th edition, © 2007
1990
$100
1990 2006
$100
You could buy 50 Big Macs in year 1990.
You can only buy 28.5 Big Macs in year 2006.
$2.00 / unit $3.50 / unit75% Price change due to inflation
The $100 in year 2006 has only $57 worth purchasing power of 1990
Purchasing Power
Contemporary Engineering
Economics, 4th edition, © 2007
2004 2005 2006 2007
$100
2004 2005 2006 2007
$100
You could purchase 63.69 gallons of purified drink water a year ago.
You can now purchase 80 gallons of purifieddrink water.
$1.57 / gallon $1.25 / gallonPrice change due to
deflation
20.38%
Deflation
Contemporary Engineering
Economics, 4th edition, © 2007
Inflation Terminology - I
Producer Price Index: a statistical measure of industrial price change, compiled monthly by the Bureau of Labor Statistics, U.S. Department of Labor
Consumer Price Index: 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
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.
Contemporary Engineering
Economics, 4th edition, © 2007
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) 2006
$100 $203.5 (July)
CPI for 2006 = 203.5
Consumer Price Index
Contemporary Engineering
Economics, 4th edition, © 2007
Selected Price Indexes (Index for Base Year = 100, Calendar Month = April)
Contemporary Engineering
Economics, 4th edition, © 2007
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 following equivalence equation.
$100 ( 1+ f) = $112.32f = 5.98%
2
$100
$112.32
0 1
2
Average Inflation Rate (f )
Contemporary Engineering
Economics, 4th edition, © 2007
Example 11.1 Average Inflation Rate
Contemporary Engineering
Economics, 4th edition, © 2007
Average inflation rate based on the CPI
CPI CPI f
fCPI
CPI
f
CPI n
CPI
nn
n
n
n
LNM
OQP
0
0
1
0
1
1
( ) ,_
_/
_
where The genreal inflation rate,
The consumer price index at the end period ,
The consumer price index for the base period.
General Inflation Rate (f)
Contemporary Engineering
Economics, 4th edition, © 2007
Year Cost
0 $504,000
1 538,000
2 577,000
3 629,500
What are the annual inflation ratesand the average inflation rate over 3 years?
SolutionInflation 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
f ($629,
$504,) . ./500
0001 0 0769 7 69%1 3
Example 11.2: Yearly and Average Inflation Rates
Contemporary Engineering
Economics, 4th edition, © 2007
Inflation Terminology – II 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.
Constant Dollars (An’ ): Estimates of future cash flows for year n in constant purchasing power, independent of the passage of time (or base period).
Contemporary Engineering
Economics, 4th edition, © 2007
A A f A F P f nn nn
n ' ( ) ' ( / , , )_ _
1
$1,000 (1 + 0.08)= $1,260
3ConstantDollars
n
f
3
8%_
$1,000
3ActualDollars
$1,260
3
Conversion from Constant to Actual Dollars
Contemporary Engineering
Economics, 4th edition, © 2007
Period Net Cash Flow in Constant $
Conversion Factor
Cash Flow in 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
Conversion from Constant to Actual DollarsAverage inflation rate = 5%
Contemporary Engineering
Economics, 4th edition, © 2007
A A f A P F f nn nn
n' ( ) ( / , , )_ _
1
ConstantDollars $1,260 (1 + 0.08)
= $1,000
-3
n
f
3
8%_
$1,000
3ActualDollars
$1,260
3
Conversion from Actual to Constant Dollars
Contemporary Engineering
Economics, 4th edition, © 2007
End of period
Cash Flow in Actual $
Conversion at f = 5%
Cash Flow in Constant $
Loss in 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
Conversion from Actual to Constant Dollars
Contemporary Engineering
Economics, 4th edition, © 2007
Example 11.3 Conversion from Constant to Actual Dollars
Jack Nicklaus won his first MastersGolf Championship in 1963. The prize money was $20,000.
Phil Mickelson won his first Masters Golf Championship in 2004.The prize money was $1.17M.
1963 2004
What is the worth of $20,000 in terms of purchasing power in 2004?
Contemporary Engineering
Economics, 4th edition, © 2007
Consumer Price Indexes for 1963 and 2004
1963
91.7
2004
561.23
1967
100
Average inflation rate = 4.52%
41
41
561.23 91.70(1 )
6.1203 1
4.5176%
f
f
Contemporary Engineering
Economics, 4th edition, © 2007
$20,000 in 1963 would have a purchasing power of $122,760 in 2004The average inflation rate between
1963 and 2004 was about 4.52% per year.
Contemporary Engineering
Economics, 4th edition, © 2007
What Could Jack Have Done to Match the Phil’s Prize Money?
01963
41
2004
$20,000
$1.17M
2004 $20,000( / , , 41)
$1,170,000
10.43%
F F P i
i
What it means is that if Jackwere able to invest his prize moneyat an interest of 10.43%over 41 years, he could match Phil’s prize money.
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