Contemporary Engineering Economics, 6 th edition Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved Meaning and Measure of Inflation Lecture No. 35 Chapter 11 Contemporary Engineering Economics Copyright © 2016

Contemporary Engineering Economics, 6 th edition Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved Chapter Opening Story  Purchasing Power: The Big Mac Index o An indicator of a country’s individual purchasing power. o Big Mac prices are calculated by converting the average national Big Mac prices with the latest exchange rate to U.S. dollars. o Two dominant factors are Inflation and cost of labor. Source: “The Big Mac Index,” The Economist, January 25, 2014

Contemporary Engineering Economics, 6 th edition Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved Inflation and Economic Analysis o What is inflation? o How do we measure inflation? o How do we incorporate the effect of inflation in equivalence calculation?

Contemporary Engineering Economics, 6 th edition Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved What is Inflation?  Time Value of Money Earning power o Investment opportunity Purchasing power o Decrease in purchasing power (inflation) o Increase in purchasing power (deflation)  Definition: The rate at which the general level of prices of goods and services is rising, and subsequently, purchasing power is falling

Contemporary Engineering Economics, 6 th edition Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved Inflation: Decrease in Purchasing Power 1990 $ $110 You could buy 50 Big Macs in the year 1990 with $110. You can only buy Big Macs in the year $2.20 / unit $4.62 / unit +210% Price change due to inflation The $110 in year 2015 has only $52.38 worth the purchasing power of 1990.

Contemporary Engineering Economics, 6 th edition Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved Deflation: Increase in Purchasing Power 2012 $ $100 With $100, you could purchase gallons of unleaded gasoline in With $100, you can now purchase gallons of unleaded gasoline in $3.68 / gallon$2.35 / gallon Price change due to deflation −36.14%

Contemporary Engineering Economics, 6 th edition Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved Inflation Terminology I o Producer Price Index: A statistical measure of industrial price change, compiled monthly by the Bureau of Labor Statistics, U.S. Department of Labor o 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 o Average Inflation Rate (f): A single average rate that accounts for the effect of varying yearly inflation rates over a period of several years o General Inflation Rate (f ): The average inflation rate calculated based on the CPI for all items in the market basket

Contemporary Engineering Economics, 6 th edition Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved Consumer Price Index (CPI) CPI (Old measure) − Base Period = 1967 o 1967: 100 o 2015: (May) CPI (New measure) − Base Period (1982–84) o 1982–84: 100 o 2015: (May) o Definition: A measure that examines the weighted average prices of a consumer goods and services. o How to calculate: Taking price changes for each item in the market basket of goods and services and averaging them.

Contemporary Engineering Economics, 6 th edition Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved Selected Price Indexes

Contemporary Engineering Economics, 6 th edition Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved Average Inflation Rate (f ) o Step 1: Find the actual inflated price at the end of year 2. $100 ( ) ( ) = $ o Step 2: Find the average inflation rate by solving the following equivalence equation. $100 ( 1+ f) 2 = $ f = 5.98% Given: o Base Price = $100 (year 0) o Inflation rate (year 1) = 4% o Inflation rate (year 2) = 8% Find: Average inflation rate over 2 years $100 $

Contemporary Engineering Economics, 6 th edition Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved Example 11.1: Average Inflation Rate Sample calculation for average inflation rate for gasoline  Given: P = 194.4, F = 304.2, N = 2014–2005 = 9  Find: f

Contemporary Engineering Economics, 6 th edition Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved Solution Average inflation rate for gasoline over 9 years

Contemporary Engineering Economics, 6 th edition Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved General Inflation Rate (f) Calculation Given: o CPI for 2005 = 195.3, o CPI for 2014 = Find: Formula

Contemporary Engineering Economics, 6 th edition Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved Example 11.2: Yearly and Average Inflation Rates  Given : Year cost data  Find : (1) Yearly and average inflation rates, (2) Average inflation rate (or price index) YearCost 0$504, , , ,500

Contemporary Engineering Economics, 6 th edition Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved Solution

Contemporary Engineering Economics, 6 th edition Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved o Actual dollars (A n ): Estimates of future cash flows for year n that take into account any anticipated future changes in amount caused by inflationary or deflationary effects o 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) Inflation Terminology II

Contemporary Engineering Economics, 6 th edition Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved Finding Actual Dollars Conversion from constant to actual dollars General inflation rate = 5%

Contemporary Engineering Economics, 6 th edition Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved Finding Constant Dollars Conversion from actual to constant dollars General inflation rate of 5%