Meaning and Effect of Inflation • Inflation makes future dollars less valuable than present dollars.

ENGR 301 Lecture 23 Inflation and Examples

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ENGR 301 Lecture 23

– A sandwich that cost $3.00 last year and $3.30 this year is an example of individual item inflation of 10%. – If the average price of bread purchased moves from $1.50 last year to $1.575 this year, the commodity ‘bread’ has inflated 5% per year. – If a market basket of goods used by the average individual costs $15.5994 this year vs. $15.1451 last year, general consumer inflation has increased by 3% per year.

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Effect of Inflation • Inflation causes the value of money to be reduced in the future • Inflation tends to cause goods and services to cost more • Inflation is pervasive. Many industrialized countries like to see inflation maintained at about 3% per year.

ENGR 301 Lecture 23

Interest Rate Definitions • Inflation rate (f): rate of change of the cost of an item, commodity, or market basket of goods. • Real interest rate (i’): ‘real’ interest earned on an investment - the inflation-free interest rate. • Market interest rate (i): the interest paid for borrowing money in the open market, the combined interest rate. – Note: the market interest rate also includes a margin for the lender’s risk.

‘Deflation’ is negative inflation, when goods cost less in the future. Deflation is rare.

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ENGR 301 Lecture 23

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Calculation of Inflation

i = i’ + f + (i’)(f) Market interest rate i 7.50% 7.50% 7.50% 7.50% 7.50% 7.50% 7.50% 7.50% S. El-Omari

Inflation rate f 2.00% 3.00% 4.00% 5.00% 6.00% 7.00% 8.00% 9.00%

Real interest rate i' 5.39% 4.37% 3.37% 2.38% 1.42% 0.47% -0.46% -1.38%

ENGR 301 Lecture 23

Inflation Inflation Inflation Inflation Inflation Inflation Deflation Deflation

ENGR 301 Lecture 23

Actual Dollars and Real Dollars Definitions • Actual dollars (A$): cash money - the kind you carry in your pocket. Sometimes called inflated dollars. • Real dollars (R$): constant purchasing power dollars expressed as a base year. (e.g.,1972-based dollars. These fictitious dollars are inflation-free dollars.

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Ex.: Adjusting for inflation

Actual vs. Constant Dollar Actual (current) dollar:

• Example

(A ) n

takes into account the inflation rate. Constant (real) dollar:

( A' ) n

Independent of passage of time

January 1999 base cost = $100,000 Inflation Rate for: 1999 – 2001 = 5% What is the Estimated Price in January, 2002?

• Answer:

Conversion from real to actual dollar n

An = A' n (1 + f ) = A' n ( F / P, f , n) Conversion from actual to real dollar

A' n = S. El-Omari

An

(1 + f )

n

= An ( P / F , f , n)

ENGR 301 Lecture 23

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P(1 + i) n = (100,000)(1 + 0.05) = $115,762.5 S. El-Omari

Ex.: Adjusting for inflation • Example January 1999 base cost = $100,000 Inflation Rate for: 1999 = 3% 2000 = 5% 2001 = 4% What is the Estimated Price in January, 2002?

• Answer:

P = Base Cost i = inflation rate n = number of years

C = P(1 + i) n

ENGR 301 Lecture 23

Ex.: Average Inflation Rate General average inflation rate: f Calculate the average inflation rate for a 2-year period where the first year’s inflation rate is 4%, and the second year’s rate is 8%. Use a base price of $100. Find total price at the end of second year: 100(1 + 0.04)(1 + 0.08) = $112.32 2

100,000 (1.03*1.05*1.04) = 100,000 * 1.12476

100(1 + f ) = $112.32

= $112,476.00

f = 5.98%

100 (F/P,f,2) = $112.32 Constant (real) dollars

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ENGR 301 Lecture 23

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Actual (current) dollar ENGR 301 Lecture 23

Examples

Examples 5000

5000

5000

15000

15000

5000

A

3000 15000

15000

AE = -15,000 (A/P, 12%,3) –3000 +5000 (A/F,12%,3) = -$7763 8000 2000 20000

8000 2000

20000

8000 2000

20000

B

AE = -20,000 (A/P, 12%,4) –2000 +8000 (A/F,12%,3) = -$6910.8

Select B S. El-Omari

ENGR 301 Lecture 23

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ENGR 301 Lecture 23

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2

Examples

Examples

Select A1

Select A2

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ENGR 301 Lecture 23

20000(A/P,12,6) -3000(P/G,12%,5)(P/F,12,1)(A/P,12,6) -5000

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Examples

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ENGR 301 Lecture 23

ENGR 301 Lecture 23

Examples

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ENGR 301 Lecture 23

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