Chapter 5 - Effects of Inflation
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Tanveer Ahmed HakroChapter 5 - Effects of Inflation
Uploaded by
Tanveer Ahmed HakroChapter 5
Effects of Inflation
Engineering Economy
By: Leland Blank . Anthony Tarquin
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5.1Understanding the Impact of Inflation
Inflation occurs because the value of the currency has changed —it has
gone down in value.
Inflation is an increase in the amount of money necessary to obtain
the same amount of goods or services before the inflated price was
present.
Purchasing power, or buying power, measures the value of a currency in
terms of the quantity and quality of goods or services that one unit of
money will purchase. Inflation decreases the purchasing ability of
money in that less goods or services can be purchased for the same
one unit of money.
Make no mistake: Inflation is a formidable force in our economy
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5.1.1Comparisons between monetary
amounts
To make comparisons between monetary amounts that
occur in different time periods, the different-valued money
first must be converted to constant-value money in order to
represent the same purchasing power over time.
Money in one period of time t1 can be brought to the
same value as money in another period of time t2 by
using the equation
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If f represents the inflation rate per period (year) and n is
the number of time periods (years) between t1 and t2,
previous equation becomes,
There are three different rates that are important to
understand inflation:
• Real interest rate (i),
•market interest rate (if),
•the inflation rate (f).
Only the first two are interest rates.
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1.Real or inflation-free interest rate i. This is the rate at
which interest is earned when the effects of changes in the
value of currency (inflation) have been removed. Thus, the
real interest rate presents an actual gain in purchasing
power.
The required real rate for corporations (and many
individuals) is set above this safe rate when a MARR is
established without an adjustment for inflation.
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2.Inflation-adjusted or market interest rate if . As its name
implies, this is the interest rate that has been adjusted to take
inflation into account. This is the interest rate we hear
everyday. It is a combination of the real interest rate i and the
inflation rate f, and, therefore, it changes as the inflation rate
changes. It is also known as the inflated interest rate.
A company’s MARR adjusted for inflation is referred to as the
inflation-adjusted or market MARR.
3.Inflation rate f. This is a measure of the rate of change in the
value of the currency.
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Deflation
It is the opposite of inflation in that when deflation is present, the
purchasing power of the monetary unit is greater in the future
than at present. That is, it will take fewer rupees in the future to
buy the same amount of goods or services as it does today.
Temporary price deflation may occur in specific sectors of the
economy due to the introduction of improved products, cheaper
technology, or imported materials or products that force current
prices down.
Deflation over a short time in a specific sector of an economy can
be orchestrated through dumping.
An example of dumping may be the importation of materials, such
as steel, cement, or cars, into one country from international
competitors at very low prices compared to current market prices
in the targeted country.
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Engineering economy computations that consider deflation
use the same relations as those for inflation.
For example, if deflation is estimated to be 2% per year, an
asset that costs $10,000 today would have a first cost 5 years
from now determined by Equation [5.3].
n 5
10,000(1 -f) = 10,000(0.98) = 10,000(0.9039) = $9039
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5.2Present Worth Calculations Adjusted
for Inflation
When the dollar amounts in different time periods are to be
expressed in constant-value dollars, the equivalent present and
future amounts must be determined using the real interest rate i.
There are two ways to make meaningful economic calculations
when the value of the currency is changing:
(1) Convert the amounts that occur in the different time periods
into amounts that make the currencies have the same value
before time value calculations are made.
(2) Change the interest rate that is used in the economic
equations in such a way that it accounts for the different
valued currencies as well as the time value of money.
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The first case is called making calculations in constant-value
dollars/rupees (also known as today's rupees). Money in one
period of time, t1, will have the same value as money in another
period of time, t2, when the t2 amount is divided by the
inflation that occurred between the two time periods. The
general equation is;
Let dollars in period t1 be called today's dollars and dollars in
period t2 be called future dollars or then-current dollars. If f
represents the inflation rate per period and n is the number of
periods between t1 and t2,
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Once this conversion has been made, then the interest rate that
must be used in the economic equations is the real interest rate.
The real interest rate, i, is the rate that represents time-value-of-
money-only considerations when money is moved from one
time period to another. This is the rate that was used in all
calculations up to this point. The market interest rate (or
inflated interest rate) is a combination of the real interest rate, i,
and the inflation rate, f. In equation form, the inflated interest
rate, if, is
where i = real interest rate
f = inflation rate
if = inflated interest rate
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Two procedures can be used for making present worth
calculations when inflation must be taken into account:
(1) Convert then-current dollars into constant value dollars
(by dividing them by the inflation rate) and then using the
real-interest rate in the equations, or
(2) do-not convert then current dollars into today's dollars
(i.e. leave them as then-current) but use the inflated interest
rate, if, in the economic equations.
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Example: Find the present worth of $20,000 (then-current dollars) in
year 10 at a real interest rate of 10% per year and an inflation rate of
6% per year when using (a) the real interest rate, and (b) the inflated
interest rate
Solution - (a) when using the real interest rate, the currency must be
expressed in constant value dollars. Thus,
Constant value dollars = 20,000
(1 + 0.06)10
= $11,168
Now, use the real interest rate (i.e. 10%) in the P/F formula:
P = 11,168 (P/F, 10%, 10)
= 11,168 (0.3855)
= $4,305
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(b) Findthe inflated interest rate and use then-current
dollars in the P/F formula:
if = 0.10 + 0.06 + (0.10) (0.06)
= 16.6%
P = 20,000 (P/F, 16.6%, 10)
= 20,000 1
(1 + 0.166)10
= $4,305
Thus, the present worth could be found using either
procedure, but the latter is usually faster when there are
many cash flows that must be converted into constant value
dollars (such as when a uniform series is involved).
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5.3Future Worth Calculations
Adjusted for Inflation
In future worth calculations, a future amount F can have any one of
four different interpretations:
Case 1. The actual amount of money that will be accumulated at
time n.
Case 2. The purchasing power of the actual amount accumulated at
time n, but stated in today’s (constant-value) dollars.
Case 3. The number of future dollars required at time n to maintain
the same purchasing power as today; that is, inflation is
considered, but interest is not.
Case 4. The amount of money required at time n to maintain
purchasing power and earn a stated real interest rate.
Depending upon which interpretation is intended, the F value is
calculated differently.
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Hyperinflation
Most countries have inflation rates in the range of 2% to 8% per
year, but hyperinflation is a problem in countries where political
instability, overspending by the government, weak international
trade balances, etc., are present.
Hyperinflation rates may be very high—10% to 100% per
month.
In a hyper inflated environment, people usually spend all
their money immediately since the cost of goods and services
will be so much higher the next month, week, or day.
Good economic decisions in a hyper inflated economy are
very difficult to make using traditional engineering economy
methods, since the estimated future values are totally
unreliable and the future availability of capital is uncertain.
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Important: Look through simple problems related to Topics
covered in Chapter.
Good luck
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