Meaning and Measure of Inflation Lecture No 35 Chapter 11 Contemporary Engineering Economics Copyright © 2016 th Contemporary Engineering Economics, edition Park Copyright © 2016 by Pearson Education, Inc All Rights Reserved 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 th Contemporary Engineering Economics, edition Park Copyright © 2016 by Pearson Education, Inc All Rights Reserved Inflation and Economic Analysis o What is inflation? o How we measure inflation? o How we incorporate the effect of inflation in equivalence calculation? th Contemporary Engineering Economics, edition Park Copyright © 2016 by Pearson Education, Inc All Rights Reserved 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 th Contemporary Engineering Economics, edition Park Investment opportunity Decrease in purchasing power (inflation) Increase in purchasing power (deflation) Copyright © 2016 by Pearson Education, Inc All Rights Reserved 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 th Contemporary Engineering Economics, edition Park Copyright © 2016 by Pearson Education, Inc All Rights Reserved 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 th Contemporary Engineering Economics, edition Park Copyright © 2016 by Pearson Education, Inc All Rights Reserved 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 th Contemporary Engineering Economics, edition Park Copyright © 2016 by Pearson Education, Inc All Rights Reserved 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 th Contemporary Engineering Economics, edition Park • • 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) Copyright © 2016 by Pearson Education, Inc All Rights Reserved Selected Price Indexes th Contemporary Engineering Economics, edition Park Copyright © 2016 by Pearson Education, Inc All Rights Reserved Average Inflation Rate (f ) oStep 1: Find the actual inflated price at the end of year Given: o o o Base Price = $100 (year 0) Inflation rate (year 1) = 4% Inflation rate (year 2) = 8% $100 ( + 0.04) ( + 0.08) = $112.32 oStep 2: Find the average inflation rate by solving the following Find: Average inflation rate over years equivalence equation $100 ( 1+ f) = $112.32 f = 5.98% $112.32 $100 th Contemporary Engineering Economics, edition Park Copyright © 2016 by Pearson Education, Inc All Rights Reserved Example 11.1: Average Inflation Rate Sample calculation for average inflation rate for gasoline Given: P = 194.4, F = 304.2, N = 2014–2005 = Find: f th Contemporary Engineering Economics, edition Park Copyright © 2016 by Pearson Education, Inc All Rights Reserved Solution • Average inflation rate for gasoline over years th Contemporary Engineering Economics, edition Park Copyright © 2016 by Pearson Education, Inc All Rights Reserved 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% th Contemporary Engineering Economics, edition Park 1/9 −1 Copyright © 2016 by Pearson Education, Inc All Rights Reserved Example 11.2: Yearly and Average Inflation Rates Given: Year cost data Year Cost $504,000 538,000 577,000 629,500 Find: (1) Yearly and average inflation rates, (2) Average inflation rate (or price index) th Contemporary Engineering Economics, edition Park Copyright © 2016 by Pearson Education, Inc All Rights Reserved Solution th Contemporary Engineering Economics, edition Park Copyright © 2016 by Pearson Education, Inc All Rights Reserved 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) th Contemporary Engineering Economics, edition Park Copyright © 2016 by Pearson Education, Inc All Rights Reserved Finding Actual Dollars • Conversion from constant to actual dollars th Contemporary Engineering Economics, edition Park • General inflation rate = 5% Copyright © 2016 by Pearson Education, Inc All Rights Reserved Finding Constant Dollars • Conversion from actual to constant dollars th Contemporary Engineering Economics, edition Park General inflation rate of 5% Copyright â 2016 by Pearson Education, Inc All Rights Reserved ... Pearson Education, Inc All Rights Reserved Inflation and Economic Analysis o What is inflation? o How we measure inflation? o How we incorporate the effect of inflation in equivalence calculation?... Reserved 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... 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