3360 UNIT 14 2014-I-01

ENGR 3360U Winter 2014Unit 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

2013-IV-0117-2 Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco


Course Outline1. Engineering Economics2. General Economics

1. Microeconomics2. Macroeconomics3. Money and the Bank of

Canada3. Engineering Estimation4. Interest and Equivalence5. Present Worth Analysis6. Annual Cash Flow7. Rate of Return Analysis8. Picking the Best Choice9. Other Choosing Techniques

10. Uncertainty and Risk11. Income and Depreciation12. After-tax Cash Flows13. Replacement Analysis14. Inflation15. MARR Selection16. Public Sector Issues17. What Engineering should know

about Accounting18. Personal Economics for the

Engineer

2013-IV-01 Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco17-3


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


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


Inflation• Inflation depends on:

– Money supply• If there is too much money in the system in relation to goods and

services, the value tends to decrease.– 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• Producers of goods and services push the cost of increasing

operating costs to consumers.– Demand-pull

• More demand (exceeding supply) tends to increase prices.


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 rate—because it includes both inflation and real interest)


14.2 Rates and Dollars

• Mathematical relationship for market rate:i = i’ + f + i’f

• 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)


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?



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 + i’f and i’ = (i-f)/(1+f)i’ = (0.055-0.02)/(1+0.02) = 0.034 or 3.4%



Relationships

• Shows the relationship between A$ and R$ when these occur in the same period of time.


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.


14.4 Price Change Indexes

• Comparing 2008-based dollars with 2010-based dollars is like comparing apples and oranges.– They don’t 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


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


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.


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 after-tax rates of return.

– Inflation reduces the after-tax rate of return even if the benefits increase at the same rate as the inflation.


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 + i’f


Summary, cont’d.

• 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.

Documents

3360 UNIT 14 2014-I-01