1. www.izmirekonomi.edu.tr L11: Measure of Inflation ECON 320 Engineering Economics Mahmut Ali GOKCE Industrial Systems Engineering Computer Sciences

2. www.izmirekonomi.edu.tr Chapter 4 Equivalence Calculations Under Inflation Measure of Inflation Actual versus Constant Dollars Equivalence Calculations under Inflation

3. www.izmirekonomi.edu.tr All-Time Top 10 Movies

4. www.izmirekonomi.edu.tr Inflation and Economic Analysis  What is inflation?  How do we measure inflation?  How do we incorporate the effect of inflation in equivalence calculation?

5. www.izmirekonomi.edu.tr What is Inflation?  Value of Money  Earning Power  Purchasing Power Earning Power Purchasing power Investment Opportunity Decrease in purchasing power (inflation) Increase in Purchasing Power (deflation)

6. www.izmirekonomi.edu.tr Purchasing Power 1990 $100 1990 2003 $100 You could buy 50 Big Macs in year 1990. You can only buy 40 Big Macs in year 2003. $2.00 / unit $2.50 / unit 25% Price change due to inflation The $100 in year 2003 has only $80 worth purchasing power of 1990

7. www.izmirekonomi.edu.tr -2 -1 0 1 $100 -2 -1 0 1 $100 You could purchase 63.69 gallons of unleaded gas a year ago. You can now purchase 80 gallons of unleaded gas. $1.57 / gallon$1.25 / gallon Price change due to deflation 20.38%

8. www.izmirekonomi.edu.tr Inflation Terminology - I Producer Price Index: a statistical measure of industrial price change, compiled monthly by the BLS, 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.

9. www.izmirekonomi.edu.tr Measuring Inflation 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) 2002 $100$179.9 CPI for 2002 = 179.9

10. www.izmirekonomi.edu.tr Selected Price Indexes

11. www.izmirekonomi.edu.tr Average Inflation Rate (f) 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) = $112.32 f = 5.98% 2 $100 $112.32 0101 2

12. www.izmirekonomi.edu.tr Example 4.1 Average Inflation Rate Item2003 Price 2000 Price Average Inflation Rate (%) Consumer price index (CPI)$184.20$171.202.47 Postage0.370.336.44 Homeowners Insurance603.00500.007.56 Private college tuition and fees18,27315,5185.60 Gasoline1.651.561.89 Haircut12.0010.504.55 Car (Toyota Camry)22,00021,0001.56 Natural gas (MBTU)5.673.1721.38 Baseball tickets148.66132.443.92 Cable TV47.9736.979.07

13. www.izmirekonomi.edu.tr General Inflation Rate (f) Average inflation rate based on the CPI

14. www.izmirekonomi.edu.tr Example 4.2: Yearly and Average Inflation Rates YearCost 0$504,000 1538,000 2577,000 3629,500 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