ES 312b – Engineering Economy 1st Sem S.Y.

2020-2021

INFLATION AND PRICE CHANGES

In earlier chapters, we assumed that the prices for goods and services in the
marketplace remain relatively unchanged over extended periods of time. Unfortunately,
this is not generally a realistic assumption.

General Price Inflation

General price inflation is defined as an increase in the prices paid for goods and
services bringing out a reduction in the purchasing power of the monetary unit. It is a
businessreality whch can affect te economic comparison of alternatives.
One measure of price changes in an economy and an estimate of general pirce
inflation is the consumer price index (CPI). CPI is a composite price inde that measures
price changes in food, shelter, medical care, transportation, apparel, and other selected
goods and services used by individuals and families.

The annual inflation rates are calculated as follows.

(𝐶𝑃𝐼)𝑘 −(𝐶𝑃𝐼)𝑘−1
(𝐶𝑃𝐼 𝑎𝑛𝑛𝑢𝑎𝑙 𝑖𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛 𝑟𝑎𝑡𝑒)𝑘 = (𝐶𝑃𝐼)𝑘−1
𝑥 100 equation 4

For example, using the table below, the CPI Annual Inflation Rate for 1994 is

(𝐶𝑃𝐼)1994 − (𝐶𝑃𝐼)1993
(𝐶𝑃𝐼 𝑎𝑛𝑛𝑢𝑎𝑙 𝑖𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛 𝑟𝑎𝑡𝑒)1994 = 𝑥 100
(𝐶𝑃𝐼)1993

148.2 − 144.5
(𝐶𝑃𝐼 𝑎𝑛𝑛𝑢𝑎𝑙 𝑖𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛 𝑟𝑎𝑡𝑒)1994 = 𝑥 100 = 2.56%
144.5

Table 1. CPI and Related Annual Inflation Rate (%), 1970-1994

Year Annual Average CPI Annual Year Annual CPI Annual
CPI Inflation Rate (%) Average CPI Inflation Rate (%)
1970 38.8 5.72 1983 99.6 3.21
1971 40.5 4.38 1984 103.9 4.32
1972 41.8 3.21 1985 107.6 3.56
1973 44.4 6.22 1986 109.6 1.86
1974 49.3 11.04 1987 113.0 3.65
1975 53.8 9.13 1988 118.3 4.14
1976 56.9 5.76 1989 124.0 4.82
1977 60.6 6.50 1990 130.7 5.40
1978 65.2 7.59 1991 136.2 4.21
1978 72.6 11.35 1992 140.3 3.01
1980 82.4 13.50 1993 144.5 2.99
1981 90.9 10.32 1994 148.2 2.56
1982 96.5 6.16
Source: CPI Detailed Report ( January 1995), U.S. Department of Labor, Bureau of Labor Statistics (Washington D.C., U.S.
Government)

Engr. Alvin John R. Villanueva

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ES 312b – Engineering Economy 1st Sem S.Y. 2020-2021

Aside fro CPI, the Producer Price Index (PPI) and the Implicit Price Index for the
Gross National Product (IPI-GNP) are two indexes that are often used to estimate general
price inflation.

To facilitate the development and discussion o the methodology for including

price changes of goods and services in engineering economy studies, we need to define
and discuss sme terminology and basic concepts. The dollar is used as a monetary unit
except when discussing other currency.

1. Actual dollars (A$) – the number of dollars associated with cash flows (or a
non-cash flow amount such as depreciation) as of the time it occurs. It is
sometimes reffered as current dollar, then-current dollars, and inflated
dollars, and their purchasing power is affected by general price inflation. It is
a term describing income in the year in which a person, household, or family
receives it. For example, the income someone received in 1989 unadjusted
for inflation is in current dollars.
2. Real dollars (R$) – dollars expressed in terms of same purchasing power,
relative to a particlar time. Sometimes R$ are termed constant dollars. They
are terms describing income after adjustment for inflation. It is a value
expressed in dollars adjusted for purchasing power.
3. General price inflation rate (f)– A measure of the change in the purchasing
power of a dollar during a specified period of time. The general price inflation
rate (applies also to deflation situation) is defined by a selected, broadly
based index of market price changes. In engineering economic analysis, the
rate is projected for a future time interval and usually is expressed as an
effective annual rate.
4. Combined (nominal) interest rate (ic) – the money paid for the use of capital,
normally expressed as nominal rate (%) that includes a market adjustment
for the anticipated general price price inflation rate in the economy. Thus, it
is a market interest rate and represents the time value cange in the future
cashflows that takes into account both potential real earning power of money
and the estimated general price inflation in the economy.
5. Real interest rate (ir) - the money paid for the use of capitaln normally
expressed as a nominal rate (%) tht does not include a market adustment for
the anticipated genera price inflation rate in the economy. It represents the
time value change in future cash flows based only on the potential real
earning power of money. It is sometime s called inflation-free interest rate.
6. Base time period (b) - the reference or base time period used to defeint the
ourchasing power of real (constant) dollars. Often in practice, the base time
period is designated as the time the engineering economic analysis, or
reference time 0. (i.e., b=0). However, b can be designated at any point in
time.

Engr. Alvin John R. Villanueva

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ES 312b – Engineering Economy 1st Sem S.Y. 2020-2021

The Relationship Between Actual Dollars and Real Dollars

Actual dollars as of any point in time, k, can be converted into real dollars of constant
market purchasing power as of any base time period, b, by the following relationship for a given
b vaue.
1 𝑘−𝑏
(𝑅$)𝑘 = (𝐴$)𝑘 ( ) = (𝐴$)𝑘 (𝑃⁄𝐹 , 𝑓%, 𝑘 − 𝑏) equation 5
1+𝑓

This relationship between actual dollars and real dollars applies to the unit prices, or costs of fixed
amounts on individual goods or services, used to develop the individual cash flows.

Example:

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

End of Year, k Salary (A$)

1 $35,000
2 37,100
3 39,326
4 41,685

If the general price inflation rate (f) is expected to average 8% per year, what is the real dollar
equivalent of these actual dollar amounts? Assume that the base time period is year 1, b = 1.

Solution:

By using equation 5, the real dollar salary equivalents are readily calculated for the base
point in time , b = 1.

Year Salary (R$ in year 1)

1 $35,000(P/F, 8%, 0) = $35,000
2 37,000(P/F, 8%, 1) = 34,351
3 39,326(P/F, 8%, 2) = 33,714
4 41,685(P/F, 8%, 3) = 33, 090

In year one ( the designated base time period for analysis), the annual salary in actual dollars
remained unchanged when converted to real dollars. This illustrates an important point: in the
base time period, the purchasing power of an actual dollar and real dollar is the same. R$b=A$b.
This example illustrates the results when an actual annual rate of increase in salary ( 6% in this
example) is less than the general price inflation rate (f). AS you can see, the actual dollar salary

Engr. Alvin John R. Villanueva

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ES 312b – Engineering Economy 1st Sem S.Y. 2020-2021

cash flow shows a reasonable increase, but a decrease in the real dollar salary cash flow occurs
(thus a derease in masket purchasing power).

The Correct Interest Rate to Use in Engineering Economy Studies

In general, the interest rate that is appropriate for equivalence calculations in engineering
economy studies depends on the type of cash flows estimates:

Method If cash flows are in terms of Then the interest rate to use is
A Actual dollars A$ Combined interest rate, ic
B Real Dollars R$ Real Interest rate, ir

The table above should make intuitive sense as follows. If one is estimating cash flows in terms of
actual (inflated) dollars, the combined interest rate ( market interest rate with inflation
component) is used. Similarly, if one is estimating cas flows in terms of real dollars, the real
(inflation-free) interest rate is used. Thus one can make economic analyses in either the actual or
real dollar domains with equal validity, provided that the appropriate interest rate is used for
equivalence calculations.

The Relationship Among the Combined and Real Interest Rates and The General Inflation Rate.

It is desirable to do engineering economic studies in terms of either actual dollars or real

dollars. Thus, the relationship between the two dollar domains is important, as well as the
relationship among ic. ir ,and f, so that the equivalent worth EW of cash flows is equal to the base
time period when either an actual or a real dollar analysis is used.

The equivalent worth of an actual dollar amount in the base time period (b), using
combined interest rate is
1
𝐸𝑊𝑏 = (𝐴$𝑘 ) (1+𝑖 𝑘−𝑏 equation 6
𝑐)

The equivalent worth of a real dollar amount in the base time period (b), using the real
interest rate is

1
𝐸𝑊𝑏 = (𝑅$𝑘 ) (1+𝑖 𝑘−𝑏 e equation 7
𝑟)

𝑖𝑐 = 𝑖𝑟 + 𝑓 + 𝑖𝑟 (𝑓) equation 8
𝑖𝑐 −𝑓
𝑖𝑟 = 1+𝑓
equation 9

The combined interest rate is the sum of the real interest rate (ir) and the general price inflation
rate (f), plus the product of those two terms. Also shown in equation 6, the real interest rate
can be calculated from the combined interest rate and general price inflation rate. Similarly,

Engr. Alvin John R. Villanueva

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ES 312b – Engineering Economy 1st Sem S.Y. 2020-2021

the IRR of a real dollar cash flow is related to the IRR of an actual dollar cash flow ( with the
same purchasing power each period) as follows:
𝐼𝑅𝑅𝑐 −𝑓
𝐼𝑅𝑅𝑟 = 1+𝑓
equation 10

Example:

If a company borrowed $100,000.00 tday to be repaid at the end of three years at

combined (market) interest rate of 11%, what is the actual dollar amount owed at the end of three
years, the real rate of return to the lender, and the real dollar amount equivalent in purchasing
power to the actual dollar amount at the end of the third year? Assume that the base or reference
year is now (b = 0), and the general price inflation rate (f) is 5% per year.

Solution:

In three years, the company will owe the original $100,000.00 plus interest that has
accumulated, in actual dollars.

𝐴$3 = 𝐴$0 (𝐹 ⁄𝑃 , 𝑖𝑐 %, 3) = $100,000( 𝐹 ⁄𝑃 , 11%, 3) = $136,763

With this payment, the actual internal rate of return, IRRc, to the lender is 11 percent. Thus the
real rate of return to the lender can be calculated based on equation 10.
𝐼𝑅𝑅𝑐 − 𝑓 0.11 − 0.05 0
𝐼𝑅𝑅𝑟 = = = , 𝑜𝑟 5.714%
1+𝑓 1 + 0.05 05714
The real interest rate in this example is the same as IRRr. Using this value for ir, the real dollar
amount equivalent in purchasing power to the actual dollar amount owed is

𝑅$3 = 𝑅$0 (𝐹 ⁄𝑃, 𝑖𝑟 %, 3) = $100,000(𝐹 ⁄𝑃, 5.714,3) = %118,140

This amount can be verified by the following calculation base on equation 5.

𝑅$3 = 𝐴$3 (𝑃⁄𝐹 , 𝑓%, 3) = $136,763(𝑃⁄𝐹 , 5%, 3) = $118,140

Example:

In example above, your salary is $35,000 in year one, and projected to increase at a rate
of 6% per year through year four, and the general price inflation rate was expected to be 8%. Your
resulting estimated salary for the four years in actual and real dollars are as follows:

End of Year, k Salary (A$) Salary (R$)b= 1

1 $35,000 $35,000
2 37,100 34,351
3 39,326 33,714
4 41,685 33, 090

Engr. Alvin John R. Villanueva

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ES 312b – Engineering Economy 1st Sem S.Y. 2020-2021

What is the equivalent worth EW of the four-year actual and real dollar salary cash flows at the
end of year one (base year) if your personal MARR is 10% per year, ic?

Solution:

(a) Actual dollar salary cash flow

𝐸𝑊(10%)1 = $35,000 + 37,100(𝑃⁄𝐹 , 10%, 1) + 39,326(𝑃⁄𝐹 , 10%, 2)
+ 41,685(𝑃⁄𝐹 , 10%, 3)
𝐸𝑊(10%)1 = $132,545

(b) Real dollar salary cash flow

𝑖𝑐 − 𝑓 0.10 − 0.08
𝑖𝑟 = = = 0.01852, 𝑜𝑟 1.852%
1+𝑓 1.08
𝐸𝑊(1.852%)1 = $35,000 + 34,351(𝑃⁄𝐹 , 1.852%, 1) + 33,714(𝑃⁄𝐹 , 1.852%, 2)
+ 33,090(𝑃⁄𝐹 , 1.852%, 3)
𝐸𝑊(1.825%)1 = $132,545

Thus, we obtain the same equivalent worth at the end of year one (the base time period) for both
actual dollar and real dollar four-year salary cash flows when the appropriate interest rate is used
for the equivalence calculations.

Inflation

Since inflation is the increase in the prices of goods and services from one year to another,
the purchasing power of money decreases.

𝐹𝐶 = 𝑃𝐶(1 + 𝑓)𝑛
Where: PC = Present cost of a commodity (goods or services)

FC = Future cost of the same commodity

f = general price inflation rate

n = number of years

Example:

An item presently cost P1,000.00. If inflation rate is at 8% per annum, what will be the
cost of the item in two years.

Solution:

𝐹𝐶 = 1000(1 + 0.08)2
𝐹𝐶 = 1166.40

Engr. Alvin John R. Villanueva

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ES 312b – Engineering Economy 1st Sem S.Y. 2020-2021

In an inflationary economy, the buying power of money decreases as cost increases. Thus,
𝑃
𝐹=
(1 + 𝑓)𝑛

Where F = future worth measured in todays’ currency.

P = todays’ currency.

Example:

An economy is experiencing inflation at an annual rate of 8%. If this continues, what will
P1,000.00 worth two years from now in terms of todays pesos?

Solution:
𝑃 1,000.00
𝐹= 𝑛
= = 𝑃857.34
(1 + 𝑓) (1 + 0.08)2

If the interest is being compunded at the same time the inflation is occuring, the future worth will
be:

𝑃(1 + 𝑖)𝑛 1+𝑖 𝑛

𝐹= = 𝑃 ( )
(1 + 𝑓)𝑛 1+𝑓
Example:

A man invested P10,000at an interest rate of 10% compounded annually. What will be
the final amount of his investment, interms of today’s pesos after five years, if an inflation
remains the same at the rate of 8% per annum?
1+𝑖 𝑛 1+0.1 5
𝐹 = 𝑃 (1+𝑓) = 10000 (1+0.08) = 10,960.86 pesos

Engr. Alvin John R. Villanueva

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