Lecture no35 meaning and measure of inflation

Chapter Opening Story  Purchasing Power: The Big Mac Index o An indicator of a country’s individual purchasing power.. o Big Mac prices are calculated by converting the average nation

Meaning and Measure of Inflation

Lecture No 35

Chapter 11

Contemporary Engineering Economics

Copyright © 2016

Chapter Opening Story

 Purchasing Power: The Big Mac Index

o An indicator of a country’s individual purchasing

power.

o Big Mac prices are calculated by converting the

average national Big Mac prices with the latest

exchange rate to U.S dollars.

o Two dominant factors are Inflation and cost of labor.

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?

What is Inflation?

 Time Value of Money

• Earning power

o Investment opportunity

• Purchasing power

o Decrease in purchasing power (inflation)

o Increase in purchasing power (deflation)

 Definition: The rate at which the general

level of prices of goods and services is

rising, and subsequently, purchasing

power is falling

Inflation: Decrease in Purchasing Power

1990

$110

1990 2015

$110

You could buy 50 Big Macs in the year 1990 with

$110.

You can only buy 23.81 Big Macs in the year 2015.

$2.20 / unit +210% $4.62 / unit

Price change due to inflation

The $110 in year 2015 has only $52.38 worth the purchasing power of 1990.

Deflation: Increase in Purchasing Power

2012

$100

2012 2015

$100

With $100, you could purchase 27.17

gallons of unleaded gasoline in 2012.

With $100, you can now purchase 42.55 gallons of unleaded gasoline in 2015.

$3.68 / gallon $2.35 / gallon

Price change due to deflation

−36.14%

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 ( ): A single average rate that accounts for the effect of varying yearly inflation rates over a period of several years

o General Inflation Rate ( ): The average inflation rate calculated based on the CPI for all items in the market basket

Consumer Price Index (CPI)

• CPI (Old measure) − Base Period = 1967

o 1967: 100

o 2015: 712.35 (May)

• CPI (New measure) − Base Period (1982–84)

o 1982–84: 100

o 2015: 237.85 (May)

o Definition : A measure that examines the

weighted average prices of a consumer

goods and services.

o How to calculate : Taking price changes

for each item in the market basket of

goods and services and averaging them

Selected Price Indexes

Average Inflation Rate (f )

o Step 1 : Find the actual inflated price at the end of year 2 $100 ( 1 + 0.04) ( 1 + 0.08) = $112.32

o Step 2 : Find the average inflation rate by solving the following equivalence equation.

$100 ( 1+ f)2 = $112.32

f = 5.98%

Given:

o Base Price = $100 (year 0)

o Inflation rate (year 1) = 4%

o Inflation rate (year 2) = 8%

Find: Average inflation rate over 2 years

$112.32

0 1

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

• Average inflation rate for gasoline over 9

years

General Inflation Rate (f)

Calculation

• Given :

o CPI for 2005 = 195.3,

o CPI for 2014 = 236.4

• Find :

• Formula

1/9

236.4

1 195.3

2.14%

=

f

Example 11.2: Yearly and Average Inflation Rates

 Given : Year cost data

 Find : (1) Yearly and average inflation rates, (2) Average inflation rate (or price index)

Solution

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)

Inflation Terminology II

Finding Actual Dollars

Finding Constant Dollars