Engineering Economy_ inflation and deflation

details of inflation and deflation

1. Engineering Economy Chapter 5

2. Inflation and Deflation Fluctuation in prices of goods Prices going up is inflation Prices going down is deflation Inflation is more common historically As prices increase, purchasing power of money declines

3. Price Index The ratio of the historical price of some commodity or service at some point in time to the price at some earlier point Consumer price index (CPI) measures the price changes of common necessities or “market basket” that would effect the whole community/families and individuals (food, medicines, apparel etc.).

4. CPI CPI is usually tabulated taking a year in the past as the base, where the CPI would be 1 If 1967 is taken as the base year, CPI for 2010 would be Average price in 2010/ Av. price in 1967 To calculate the CPI annual inflation rate for a given year that falls in the 1967-2010 period: CPI annual inflation rate, k = [(CPI k – CPI k-1 )/CPI k-1 ]x 100

5. Average Inflation Rate Average annual Inflation Rate is related to CPI: CPI t [1+f av ] n = CPI t+n Average annual inflation rate is useful in estimating the individual yearly inflation rate

6. Purchasing Power of Money PP n = CPI b / CPI n PP n is the purchasing power of money in a particular year n. n occurs after the base year b that is used to define the CPI The average annual inflation rate can be related as: PP n (1+f av ) n-b = PP b

7. Effects of Inflation Market interest rate i is the opportunity to earn as reflected by the interest rates availabe in finance, businesses, banks i is usually the MARR for a new investment Inflation free interest rate i’ represents the earning power of money with the effects of inflation removed The inflation rate f is the annual % increase in prices of goods and services

8. Actual and Real currency Actual dollars A (or Rs , €, ₤, ¥) denotes the actual currency notes transacted Real / constant / todays R dollars represent the hypothetical purchasing power of future receipts and disbursements. A = (1+f) n R

9. Inflation affected Future worth P = F/[1+i] n F’ = F/[1+f] n P = F/[(1+f) n (1+i’) n ) i’ = [(1+i)/(1+f)] -1 Inflation free interest rate i ’ is also known as real interest rate

10. Example If your employer promises 6% annual salary increase and offers you a job of Rs . 350000 per year would you accept the offer considering 8% inflation rate?

11. Solution End of year Salary (Actual rupees) Salary (Real rupees) 350k 350k 1 371k 344k 2 393k 337k 3 417k 331k R = A/(1+f) n