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    Chapter 6-Price Changes & Inflation

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    Jok eR
    The document discusses inflation and how it impacts engineering economic analyses. It defines inflation and different price indices used to measure inflation. The document also covers how to convert between actual and real dollars under different inflation rates and how to account for inflation in decisions involving cash flows over time.

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    Chapter 6-Price Changes & Inflation

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    Jok eR
    21 views27 pages
    The document discusses inflation and how it impacts engineering economic analyses. It defines inflation and different price indices used to measure inflation. The document also covers how to convert between actual and real dollars under different inflation rates and how to account for inflation in decisions involving cash flows over time.

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    The document discusses inflation and how it impacts engineering economic analyses. It defines inflation and different price indices used to measure inflation. The document also covers how to convert between actual and real dollars under different inflation rates and how to account for inflation in decisions involving cash flows over time.

    Copyright:

    © All Rights Reserved
    Download as PDF, TXT or read online from Scribd
    Download as pdf or txt
    21 views27 pages

    Chapter 6-Price Changes & Inflation

    Uploaded by

    Jok eR
    The document discusses inflation and how it impacts engineering economic analyses. It defines inflation and different price indices used to measure inflation. The document also covers how to convert between actual and real dollars under different inflation rates and how to account for inflation in decisions involving cash flows over time.

    Copyright:

    © All Rights Reserved
    Download as PDF, TXT or read online from Scribd
    Download as pdf or txt
    of 27

    Beirut Arab University

    Faculty of Engineering
    Industrial Engineering and Management

    Price Changes and Exchange Rates

    Chapter 6
    Introduction

    The objective of this Chapter is to present how


    inflation/deflation is dealt with in engineering
    economy studies.
    Inflation: Definition

    Inflation describes an upward change in prices.


    Economists don’t agree on all sources of inflation, but believe that the following
    effects influence either in isolation or combination:

    1- Cost push inflation

    2- demand pull inflation

    3- Money supply

    Change in the general level of prices does not mean that all prices of all goods and
    services changed by the same amount.
    It is possible that the prices of some goods and some services rose or fell at a
    different rate or remained stable
    What is meant is the weighted-average level of prices ell or rose over this period
    Inflation - Definition

    Our assumption of constant prices for goods and services is


    generally not the case.

    General price inflation increases the average price of goods


    and services over time, while deflation results in a decrease
    in average prices (certainly a more rare circumstance).
    Inflation - Definition

    Changes in the consumer price index (CPI) and producer


    price index (PPI) are used as surrogate measures of inflation.
    “ The Consumer Price Index -CPI measures the average change in prices of
    goods and services in day to day living”.

    It is based on weighted average of a market basket of goods and services.


    The quantity and quality of items making up the market basket remain
    essentially the same between pricing periods.

    The rate of change can be found, in either case, from the formula below.
    Price Index

    Categories:
    1- Food and beverages (cereal, milk, coffee, chicken…..)
    2- Housing (rent, furniture,…)
    3- Apparel (men’s shirts and sweaters, Jewelry,…)
    4-Transportation (new vehicles, gasoline,…)
    5-Medical Care (drugs, physician’s services, hospital services…)
    6-Recreation (television, sport equipment, pets,…)
    7-Education and communication (telephone, computer software and
    accessories, postage, college tuition…)
    8- Other goods and services (Tobacco and smoking products, haircuts and
    other personal services, funeral expenses…)
    Inflation - Definition

    Example1:

    The oil refinery business has been in the news a lot.


    The general inflation rate for this industry for the
    2007 calendar year can be found using the producer
    price index (from www.bls.gov).
    Terminology and Basic Concepts

    There are a lot of terms to know!


     Actual dollars (A$), also known as current, nominal, or
    inflated dollars, represent cash at the time it occurs.
     Real dollars (R$), also known as constant dollars, are
    dollars expressed in terms of the same purchasing power
    relative to a particular time.
     General price inflation (or deflation) rate (f ), perhaps
    peculiar to particular business environment. A measure of
    the average change in the purchasing power of a dollar
    during a specified period of time. It is defined by selected,
    broadly based index of market price changes.
    Terminology and Basic Concepts

    More terms to know.


     Market (nominal) interest rate (im ) is the money paid for the
    use of capital, adjusted for anticipated general price inflation. It
    represents the time value change in future actual dollar cash
    flows that takes into account both the potential real earning
    power of money and the estimated general inflation in the
    economy.
     Real interest rate (ir ) is the money paid for the use of capital,
    not adjusted for anticipated inflation (the inflation-free interest
    rate).
     Base time period (b) is the reference or base time period used to
    define the constant purchasing power of real dollars. In practice,
    the base time period is designated .as the time of the engineering
    economic analysis, or reference time 0 (ie b=0).
    Mathematics of Inflation

    Year 1 Year 2 Year 3

    $4 $5 $6.25
    Having: $100 Unit s bought = 25 Units bought = 20 Units bought = 16

    Buying power $100 $80 $64


    Base year1

    f2=(5-4)/4*100 = 25% f3=(6.25-5)/5*100 = 25%


    Inflation rate
    The relationship between Actual Dollars and Real Dollars

    These Symbol are used:

    P = amount at year 0
    N = year
    A$ = current /Actual dollars in year N
    R$ = constant /Real dollars in year N
    f = inflation rate

    R$ = A$ ( 1+f )-N

    NB: Income tax is levied against current-money cash flow,


    not against constant-money cash flow.
    Mathematics of Inflation

    Example1:

    if the inflation rate is 20%, find the constant dollars cash flow in terms of
    year 0 of the following:

    Year current-$
    0 -10,000
    1 5,000
    2 5,000
    3 5,000
    4 5,000
    5 5,000
    Mathematics of Inflation

    Example2:

    Suppose that your salary is $35,000 in year one, will increase at 6% per year
    through year four, and is expressed in actual $ as follows: f=8%

    Year A$ R$
    1 35,000 35,000
    2 37,100 34,351
    3 39,326 33,714
    4 41,685 33,090
    Pause and solve

    Acme is considering expanding their remote packaging facility. After-tax


    cash flows for their primary alternative are presented in the table below. If the
    general price inflation rate (f) is estimated to be 3.3% per year during the six-
    year analysis period, what is the real-dollar ATCF that is equivalent to the
    actual-dollar ATCF? The base time period is year zero (b = 0).

    End of Year ATCF (A$)


    0 -380,000
    1 70,000
    2 120,000
    3 120,000
    4 180,000
    5 180,000
    6 180,000
    The relationship among im, ir and f

    It is important to use the correct dollar-type/interest-type


    combination. Otherwise, the results will be biased.

     When cash flow estimates are made using actual


    dollars, A$, the correct rate to use is the market interest
    rate, im (which is adjusted for inflation).
     When cash flow estimates are made using real dollars,
    R$, the correct rate to use is the real interest rate, ir.
    The relationship among im, ir and f

    Relating the market interest rate and the real


    (inflation free) interest rate.

    im  ir  f  ir f
    or
    Pause and solve

    Jill deposits $10,000 each year for eight years into an account
    earning 6% per year. During this time Jill expects general
    inflation to be 2% per year. At the end of eight years, what is
    the dollar value of Jill’s account in terms of today’s purchasing
    power (i.e., in real dollars)?
    Fixed and Responsive Annuities

    Caution: Fixed and responsive annuities!

    It is critical when performing engineering economic


    analyses that future cash flows be consistent, and
    perhaps converted, into either real or actual
    (constant) dollars, as appropriate, before performing
    the analysis.
    Fixed and Responsive Annuities

    Example3:

    Illustration of Fixed and Responsive Annuities with General Price Inflation


    Rate of 6% per Year

    Fixed Annuity Responsive Annuity


    End of Year K In Actual $ In Equivalent Real $ In Actual $ In Equivalent Real $
    1 $2,000 $1,887 $2,120 $2,000
    2 2,000 1,780 2,247 2,000
    3 2,000 1,679 2,382 2,000
    4 2,000 1,584 2,525 2,000
    5 2,000 1,495 2,676 2,000
    6 2,000 1,410 2,837 2,000
    7 2,000 1,330 3,007 2,000
    8 2,000 1,255 3,188 2,000
    9 2,000 1,184 3,379 2,000
    10 2,000 1,117 3,582 2,000
    Incorporating The Inflation in an economic decision

    Example4:

    The cost of a new and more efficient electrical circuit switching equipment is $180,000. it
    is estimated (in base year dollars, b=0) that the equipment will reduce current net
    operating expenses by $36,000per year (for 10 years) and will have $30,000 market value
    at the end of the 10th year. inflation rate is 8% per year.
    due to the new computer control features on the equipment, it will be necessary to
    contract for some maintenance support during the first three years.
    the maintenance contractwill cost $2,800 per year.
    this equipment will be depreciated under the MACRS(GDS) method, and it is in
    the five-year property class.
    The effective income tax rate is 38%.
    the selected analysis period is 10 years, and the
    MARR in current-$ 15% per year.

    Is this capital investment justified?


    Understanding differential price changes

     Price changes for specific goods or services do not


    necessarily follow general price inflation (or
    deflation).
     Let ej be the % price change of good j, and e'j be the %
    price change relative to the general inflation rate, f.

    Then
    ej = e'j + f + e'j(f)
    Understanding differential price changes

    Example5:

    The prospective maintenance expenses for a commercial heating, ventilating, and


    air-conditioning (HVAC) system are estimated to be $12,200 per year in base-
    year dollars (assume that b=0). The total price escalation rate is estimated to be
    7.6% for the next three years and for years four and five it is estimated to be
    9.3%. The general price inflation rate (f) for this five-year period is estimated
    to be 4.7% per year. Develop the maintenance expense estimates for years one
    through five in actual dollars and in real dollars using ej and e’j values,
    respectively.
    A$ Maintenance R$ Maintenance
    End of Year, k
    Adjustment ej expenses, A$ Adjustment e'j expenses, R$
    1 $12,200(1.076) $13,127 $12,200(1.0277) $12,538
    2 12,200(1.076)2 14,125 12,200(1.0277)2 12,885
    3 12,200(1.076)3 15,198 12,200(1.0277)3 13,242
    4 12,200(1.076)3(1.093) 16,612 12,200(1.0277)3(1.0439) 13,823
    5 12,200(1.076)3(1.093)2 18,157 12,200(1.0277)3(1.0439)2 14,430
    Spreadsheet Application

    Example6:

    Sara wishes to retire in the year 2022 with personal savings of $500,000 ( 1997
    spending power). Assume that the expected inflation rate in the economy will
    average 3.75% per year during this period. Sara plans to invest in a 7.5% per
    year savings account, and her salary is expected to increase by 8% per year
    between 1997 and 2022. assume that Sara’s 1997 salary was $60,000 and that
    the first deposit took place at the end of 1997. what percent of her salary must
    Sara put aside for retirement purposes to make her retirement plan a reality?
    Foreign Exchange Rates and Purchasing Power Concepts

    Foreign exchange rates can alter purchasing power,


    and should be considered in analyses of multiple world
    economies with varying economic circumstances. As
    exchange rates vary, the value of goods in a particular
    currency will fluctuate. The rate is analogous to
    changes in the general inflation rate.
    Foreign Exchange Rates and Purchasing Power Concepts

    Let
    Foreign Exchange Rates and Purchasing Power Concepts

    The relationship among these variables is

    or

    and
    Foreign Exchange Rates and Purchasing Power Concepts

    Example7:

    The currency of the country of Albatross, the grickle,


    is devalued against the U.S. dollar by 8% per year.
    The rate of return on an investment relative to the
    grackle in Albatross is 12%. What is the equivalent
    return relative to the dollar?

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