Lecture no35 meaning and measure of inflation
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Meaning and Measure of Inflation
Lecture No. 35
Chapter 11
Contemporary Engineering Economics
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Chapter Opening Story
o
Purchasing Power: The Big Mac Index
o
Big Mac prices are calculated by converting the
average national Big Mac prices with the latest
exchange rate to U.S. dollars.
o
An indicator of a country’s individual purchasing
power.
Two dominant factors are Inflation and cost of labor.
Source: “The Big Mac Index,” The Economist, January 25, 2014
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Inflation and Economic Analysis
o
What is inflation?
o
How do we measure inflation?
o
How do we incorporate the effect of inflation in equivalence
calculation?
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What is Inflation?
Definition: The rate at which the general
level of prices of goods and services is
rising, and subsequently, purchasing
power is falling
Time Value of Money
• Earning power
o
•
Purchasing power
o
o
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Investment opportunity
Decrease in purchasing power (inflation)
Increase in purchasing power (deflation)
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Inflation: Decrease in Purchasing Power
$110
$110
1990
1990
2015
You could buy 50 Big Macs in the year 1990 with
You can only buy 23.81 Big Macs in the year
$110.
2015.
$2.20 / unit
+210%
Price change due to
$4.62 / unit
inflation
The $110 in year 2015 has only $52.38
worth the purchasing power of 1990.
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Deflation: Increase in Purchasing Power
$100
$100
2012
2012
2015
With $100, you could purchase 27.17
With $100, you can now purchase 42.55
gallons of unleaded gasoline in 2012.
gallons of unleaded gasoline in 2015.
$3.68 / gallon
−36.14%
$2.35 / gallon
Price change due to deflation
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Inflation Terminology I
o
Producer Price Index: A statistical measure of industrial price change, compiled monthly by the Bureau of Labor Statistics,
U.S. Department of Labor
o
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
o
Average Inflation Rate (f): A single average rate that accounts for the effect of varying yearly inflation rates over a period of
several years
o
General Inflation Rate (f ): The average inflation rate calculated based on the CPI for all items in the market basket
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Consumer Price Index (CPI)
o
o
Definition: A measure that examines the
weighted average prices of a consumer
goods and services.
How to calculate: Taking price changes
for each item in the market basket of
goods and services and averaging them.
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•
•
CPI (Old measure) − Base Period = 1967
o
o
1967: 100
2015: 712.35 (May)
CPI (New measure) − Base Period (1982–84)
o
o
1982–84: 100
2015: 237.85 (May)
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Selected Price Indexes
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Average Inflation Rate (f )
oStep 1: Find the actual inflated price at the end of year 2.
Given:
o
o
o
Base Price = $100 (year 0)
Inflation rate (year 1) = 4%
Inflation rate (year 2) = 8%
$100 ( 1 + 0.04) ( 1 + 0.08) = $112.32
oStep 2: Find the average inflation rate by solving the following
Find: Average inflation rate over 2 years
equivalence equation.
2
$100 ( 1+ f) = $112.32
f = 5.98%
$112.32
0
1
2
$100
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Example 11.1: Average Inflation Rate
Sample calculation for average inflation rate for gasoline
Given: P = 194.4, F = 304.2,
N = 2014–2005 = 9
Find: f
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Solution
•
Average inflation rate for gasoline over 9
years
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General Inflation Rate (f)
•
Formula
Calculation
•
Given:
o
o
•
CPI for 2005 = 195.3,
CPI for 2014 = 236.4
Find:
f
236.4
f =
195.3
= 2.14%
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1/9
−1
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Example 11.2: Yearly and Average Inflation Rates
Given: Year cost data
Year
Cost
0
$504,000
1
538,000
2
577,000
3
629,500
Find: (1) Yearly and average inflation rates, (2) Average inflation rate (or price index)
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Solution
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Inflation Terminology II
o
Actual dollars (An): Estimates of future cash flows for year n that take into account
any anticipated future changes in amount caused by inflationary or deflationary
effects
o
Constant dollars (An’): Estimates of future cash flows for year n in constant
purchasing power, independent of the passage of time (or base period)
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Finding Actual Dollars
•
Conversion from constant to actual dollars
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•
General inflation rate = 5%
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Finding Constant Dollars
•
Conversion from actual to constant dollars
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•
General inflation rate of 5%
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