Inflation / Deflation Inflation is an increase over time in the price of a good or service with a constant value A gallon of 87 octane gasoline increases in price (but still only gets Dr. J. 32 miles down the road) Deflation is a decrease over time in the price of a good or service of constant value. A 2 GHz computer has decreased in price (but still does the same number of computations/min.)

Other Examples: Inflationary Tuition Fees Books Industry Salaries Cars Gas Deflationary CPU Memory Computers Constant Bread Milk

Average Inflation Rate (f) In most engineering econ problems, different items will have different inflation rates Average Inflation Rate is based on a market basket of goods – CPI or Consumer Price Index Simplifies cash flow in an analysis! 1.Food & Drink 2.Housing 3.Clothing 4.Transportation 5.Medical Care 6.Entertainment 7.Personal Care 8.Other Goods / Services

Deriving Equation for Inflation P = 50,000 f = 10% increase annually F 1 = 50, ,000 (.10) = 50,000 (1 +.10) = 55,000 F 2 = 55, ,000 (.10) = 55,000 (1 +.10) = 50,000 (1 +.10)(1 +.10) = 50,000 (1 +.10) 2 = 60,500 F 3 = 60, ,500 (.10) = 50,000 (1 +.10) 2 (1 +.10) = 50,000 (1 +.10) 3 = 66,550 Generally:F n = P (1 + f ) n

Constant Dollars vs. Actual Dollars Constant Dollars – represent constant purchasing power independent of the passage of time. Actual Dollars – an estimate of a future cash flow for Year n that take into account any anticipated changes in amount caused by inflationary or deflationary effects.

Constant Dollars vs. Actual Dollars f = Average Inflation Rate $785 / QTR Tuition & Fees ACTUAL $ $785 / QTR Tuition & Fees $785 (1+ f ) 32 / QTR Tuition & Fees CONSTANT $ $A = $C (1+ f ) n $C = $A (1+ f ) – n

Incorporating Inflation Inflation can be accounted for as an additional component on top of the interest rate: d = i + f + if (d replaces i in tables/equations) where: i is the effective interest rate f is the constant inflation rate

Incorporating Inflation Example If you desire a real return of 10% on your money, excluding inflation, and inflation is running 3%, what is combined discount rate you should be seeking?

Ch 15 Inflation 10 Measuring Inflation with CPI Consumer Price Index

Example using CPI  Carol and George are both engineers. In 2001, their combined income was $105,000. How much did their income need to be in 2008 to have the same purchasing power? 2001 CPI = CPI = 210

Ch 15 Inflation 12 Are the Lowest Paid Keeping up with Inflation?  Federal minimum wage $1 in 1960 $7.25 in 2009  CPI 29.8 in in 2009  Did pay increase in real terms?

Ch 15 Inflation 13 Average CPI & Minimum Wage Inflation Rates  F T + t = F T (1 + f ) t  1960 to 2009 is 49 years  CPI = 29.8 (1 + f ) 49 f = (215.9/29.8) 1/49 – 1 = 4.124%  Federal minimum wage 7.25 = 1 (1 + f MW ) 49 f MW = (7.25/1) 1/49 – 1 = 4.126%

Class Example A $50,000 Bond which has a bond interest rate of 10% per year payable semiannually is currently for sale. The bond is due in 15 years. If the rate of return required by investors is a nominal 16% per year compounded semiannually and if the inflation rate is 4.5% per semi annual period, how much should be paid for the bond (a) when inflation is not taken into account and (b) when inflation is considered.

Additional References  Eschenbach, Ted G. (2011). Engineering Economy - Applying Theory to Practice (3rd Edition).. Oxford University Press.Online version available at: wse/display?_EXT_KNOVEL_DISPLAY_ bookid=4020&VerticalID=0, Chapter 15  Blank and Tarquin. Engineering Economy (3 rd Edition) Pg 261.