Contemporary Engineering Economics, 4 th edition, © 2007 Meaning and Measure of Inflation Lecture No. 43 Chapter 11 Contemporary Engineering Economics Copyright © 2006

Contemporary Engineering Economics, 4 th 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 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, 4 th 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, 4 th edition, © 2007  Value of Money  Earning Power  Purchasing Power Earning Power Purchasing 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, 4 th edition, © $ $100 You could buy 50 Big Macs in year You can only buy 28.5 Big Macs in year $2.00 / unit $3.50 / unit 75% Price change due to inflation The $100 in year 2006 has only $57 worth purchasing power of 1990 Purchasing Power

Contemporary Engineering Economics, 4 th edition, © $ $100 You could purchase gallons of purified drink water a year ago. You can now purchase 80 gallons of purified drink water. $1.57 / gallon$1.25 / gallon Price change due to deflation 20.38% Deflation

Contemporary Engineering Economics, 4 th 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, 4 th 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 ( ) 2006 $100 $203.5 (July) CPI for 2006 = Consumer Price Index

Contemporary Engineering Economics, 4 th edition, © 2007 Selected Price Indexes (Index for Base Year = 100, Calendar Month = April)

Contemporary Engineering Economics, 4 th 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 ( ) ( ) = $ Step 2: Find the average inflation rate by solving the following equivalence equation. $100 ( 1+ f) = $ f = 5.98% 2 $100 $ Average Inflation Rate (f )

Contemporary Engineering Economics, 4 th edition, © 2007 Example 11.1 Average Inflation Rate

Contemporary Engineering Economics, 4 th edition, © 2007 Average inflation rate based on the CPI General Inflation Rate (f)

Contemporary Engineering Economics, 4 th edition, © 2007 YearCost 0$504, , , ,500 What are the annual inflation rates and the average inflation rate over 3 years? Solution  Inflation rate during year 1 (f 1 ): ($538,400 - $504,000) / $504,000 = 6.83%.  Inflation rate during year 2 (f 2 ): ($577,000 - $538,400) / $538,400 = 7.17 %.  Inflation rate during year 3 (f 3 ): ($629,500 - $577,000) / $577,000 = 9.10%. The average inflation rate over 3 years is Example 11.2: Yearly and Average Inflation Rates

Contemporary Engineering Economics, 4 th edition, © 2007 Inflation Terminology – II Actual Dollars (A n ): 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 (A n ’ ): Estimates of future cash flows for year n in constant purchasing power, independent of the passage of time (or base period).

Contemporary Engineering Economics, 4 th edition, © 2007 $1,000 ( ) = $1,260 3 Constant Dollars $1,000 3 Actual Dollars $1,260 3 Conversion from Constant to Actual Dollars

Contemporary Engineering Economics, 4 th edition, © 2007 PeriodNet Cash Flow in Constant $ Conversion Factor Cash Flow in Actual $ 0-$250,000(1+0.05) 0 -$250, ,000(1+0.05) 1 105, ,000(1+0.05) 2 121, ,000(1+0.05) 3 138, ,000(1+0.05) 4 158, ,000(1+0.05) 5 153,154 Conversion from Constant to Actual Dollars Average inflation rate = 5%

Contemporary Engineering Economics, 4 th edition, © 2007 Constant Dollars $1,260 ( ) = $1, $1,000 3 Actual Dollars $1,260 3 Conversion from Actual to Constant Dollars

Contemporary Engineering Economics, 4 th 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 -$20,0000% 120,000(1+0.05) , ,000(1+0.05) , ,000(1+0.05) , ,000(1+0.05) , Conversion from Actual to Constant Dollars

Contemporary Engineering Economics, 4 th edition, © 2007 Example 11.3 Conversion from Constant to Actual Dollars Jack Nicklaus won his first Masters Golf Championship in The prize money was $20,000. Phil Mickelson won his first Masters Golf Championship in The prize money was $1.17M What is the worth of $20,000 in terms of purchasing power in 2004?

Contemporary Engineering Economics, 4 th edition, © 2007 Consumer Price Indexes for 1963 and Average inflation rate = 4.52%

Contemporary Engineering Economics, 4 th edition, © 2007 $20,000 in 1963 would have a purchasing power of $122,760 in 2004 The average inflation rate between 1963 and 2004 was about 4.52% per year.

Contemporary Engineering Economics, 4 th edition, © 2007 What Could Jack Have Done to Match the Phil’s Prize Money? $20,000 $1.17M What it means is that if Jack were able to invest his prize money at an interest of 10.43% over 41 years, he could match Phil’s prize money.