ENGR 3360U Winter 2014
Unit 14
Inflation
Dr. J. Michael Bennett, P. Eng., PMP,
UOIT,
Version 2014-I-01
Unit 14 Inflation again!
Change Record
2014-I-01 Initial Creation
17-2
2013-IV-01
Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco
Unit 14 Inflation again!
Course Outline
1.
2.
3.
4.
5.
6.
7.
8.
9.
17-3
Engineering Economics
General Economics
1.
Microeconomics
2.
Macroeconomics
3.
Money and the Bank of
Canada
Engineering Estimation
Interest and Equivalence
Present Worth Analysis
Annual Cash Flow
Rate of Return Analysis
Picking the Best Choice
Other Choosing Techniques
2013-IV-01
10. Uncertainty and Risk
11. Income and Depreciation
12. After-tax Cash Flows
13. Replacement Analysis
14. Inflation
15. MARR Selection
16. Public Sector Issues
17. What Engineering should know
about Accounting
18. Personal Economics for the
Engineer
Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco
Unit 14 Inflation again!
Unit 14 Road Map
14.1 Inflation effect on purchasing power
14.1 Real and Actual Dollars
14.3 Constant and Then-current Dollars
14.4 Price Indexes
14.5 Cash Flows, Inflation and Tax
Calculations
Unit 14 Inflation again!
14.1 Meaning and Effect of Inflation
$100 now and $100 in the future
Purchasing power changes over time
Inflation makes future dollars less valuable
than present dollars.
When purchasing power increases over
time, this is called deflation.
Rare, but can happen
Unit 14 Inflation again!
Inflation
Inflation depends on:
Money supply
Exchange rates
Strength of the dollar in world markets subsequently changes its
value because (for example) corporations will increase prices to
make up for a loss in the world market value.
Cost-push
If there is too much money in the system in relation to goods and
services, the value tends to decrease.
Producers of goods and services push the cost of increasing
operating costs to consumers.
Demand-pull
More demand (exceeding supply) tends to increase prices.
Unit 14 Inflation again!
Inflation
Inflation rate (f)
Annual rate of increase in the number of dollars needed to
pay for the same services
Real Interest rate (i)
Measures the real growth of our money, excluding the
effect of inflation (inflation-free rate)
Increase in purchasing power
Market Interest rate (i)
The rate that one obtains in the general marketplace
(combined ratebecause it includes both inflation and real
interest)
Unit 14 Inflation again!
14.2 Rates and Dollars
Mathematical relationship for market rate:
i = i + f + if
Actual dollars A$:
What we normally think of as actually existing
physically
Sometimes called inflated dollars because they
carry the effect of inflation (decreased purchase
power)
Real dollars R$
Constant dollars that represent purchasing
power of a base year (inflation-free dollars)
Unit 14 Inflation again!
Example 14.1
A golfer wants to invest her earnings in a
bank. The bank pays 5.5% and inflation is
2%. What is her real increase in purchasing
power?
17-9
2013-IV-01
Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco
Unit 14 Inflation again!
Example 14.1
A golfer wants to invest her earnings in a
bank. The bank pays 5.5%% and inflation is
2%. What is her real increase in purchasing
power?
i = i + f + if and i = (i-f)/(1+f)
i = (0.055-0.02)/(1+0.02) = 0.034 or 3.4%
17-10
2013-IV-01
Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco
Unit 14 Inflation again!
Relationships
Shows the relationship between A$ and R$
when these occur in the same period of
time.
Unit 14 Inflation again!
14.3 Analysis
Two ways to approach economic analysis:
Ignoring Inflation (constant dollars using i)
Incorporating Inflation (then-current dollars
using the market rate i)
Constant Dollars versus Then-current Dollars
These two types must not be combined in the
same problem .
Conversion is therefore required if both are
stated.
Unit 14 Inflation again!
14.4 Price Change Indexes
Comparing 2008-based dollars with 2010based dollars is like comparing apples and
oranges.
They dont have the same purchasing power.
Price indexes describe the relative price
fluctuation of goods and services.
% Increase = ((Index(n) Index(n+m)/Index(n+m)) x 100%
Where n and m are years of evaluation
Average rate of increase:
Inflation compounds, so use:
F = P(1+i)n and solve for i
Unit 14 Inflation again!
Composite versus Commodity
Cost indexes have two types:
Composite indexes
To track historical prices of bundles or market
baskets of assets
Examples:
Consumer Price Index (CPI)
Statistics Canada provides as an indicator of inflation
Producer Price Index (PPI)
Commodity specific indexes
Examples: Construction labour, iron-ore, and other
specific products
Unit 14 Inflation again!
Different Rates of Inflation
It is not uncommon that different parameters
will inflate at different rates.
Historical Price Indexes can be used as an
indicator in future estimates.
For example:
Several commodities in an analysis may inflate
at different rates.
By using individual rates, the actual dollar
amounts can be placed in the cash flow.
Once this occurs, a market interest rate can be
used to discount the dollar values.
Unit 14 Inflation again!
14.5 Other Situations
Inflation rates can change over time.
Handle by applying the inflation rates in the years they
occur and convert to actual dollars
The market rate can then be used
After-tax calculations
The value of depreciation deductions are diminished by
inflation.
Equal before-tax rates of return do not produce equal aftertax rates of return.
Inflation reduces the after-tax rate of return even if the
benefits increase at the same rate as the inflation.
Unit 14 Inflation again!
Summary
Inflation
Characterized by the rising prices of goods and
services over time.
Future dollars have less purchasing power.
Market rate (i) reflects:
Real interest rate (i) actual increase in
purchasing power
Inflation rate (f) purchasing power effect
i = i + f + if
Unit 14 Inflation again!
Summary, contd.
Cash flows are expressed as either Actual or
Real Dollars
Market Rate is used for Actual Dollars.
Real Rate is used for Real Dollars.
Price Indexes show the historical effect of
inflation on the index category.
Can be used as an indication for future prices
After-tax rate of return calculations are
affected by inflation.
