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ENGINEERING
Newnan, Lavelle, and Eschenbach
ECONOMIC
ANALYSIS, 12/e Copyright © 2014 by Oxford University Press
 Chapter 14

Inflation and Price Change

Copyright Oxford University Press 2014

 Chapter Outline

• Meaning and Effect of Inflation

• Analysis in Constant Dollars versus Actual Dollars
• Price Change Indexes
• Cash Flows with Different Inflation Rates
• Effect of Inflation on After-tax Analysis
• Spreadsheet and Inflation Calculation

Copyright Oxford University Press 2014

 Learning Objectives

• Recognize the impact of inflation in economic

analysis
• Define real and actual dollars and interest rates
• Conduct real and actual dollars analyses
• Understand and apply price indexes
• Develop cash flows with different inflation rates
• Incorporate inflation in both before- and after-tax
calculations
• Use spreadsheet to incorporate the effects of
inflation and price change

Copyright Oxford University Press 2014

 Meaning and Effect of Inflation

• Inflation causes money to lose purchasing power.

• Inflation makes future dollars less valuable than
present dollars.
• Deflation occurs when the purchasing power of a
monetary unit increases.

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 How Does Inflation Happen?

• Money supply: money available to consumers

in the general economy increases faster than
the goods available
• Exchange rates: prices change to reflect the
comparative value of currencies in different
countries
• Cost-push: producers raise prices to cover
costs
• Demand-pull: consumers bid up prices by
attempting to buy more than is available

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 Interest Rate Definitions

• Inflation rate (𝑓𝑓): the annual rate of increase in

dollar amounts needed to pay for the same amount
of goods or services
• Real interest rate (𝑖𝑖𝑖): the interest rate of the “real”
growth of our money without the effect of inflation
(also known as the inflation-free interest rate)
• Market interest rate (𝑖𝑖): the interest one obtains in
the general marketplace (also known as the
combined interest rate)
1 + 𝑖𝑖 = (1 + 𝑖𝑖 ′ )(1 + 𝑓𝑓)
𝑖𝑖 = 𝑖𝑖 ′ + 𝑓𝑓 + (𝑖𝑖 ′ )(𝑓𝑓) (14-1)

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 Example 14-1
Real Interest Rate Calculation
Bank pays 5.5% interest compounded annually.
Inflation is expected at 2%. Identify 𝑖𝑖, 𝑓𝑓, 𝑖𝑖𝑖
𝑖𝑖 = 5.5%; 𝑓𝑓 = 2%
1 + 𝑖𝑖 = 1 + 𝑖𝑖 ′ 1 + 𝑓𝑓 ∴ 1 + 𝑖𝑖 ′ = 1 + 𝑖𝑖 ⁄(1 + 𝑓𝑓)
1 + 𝑖𝑖 ′ = 1 + 0.055 ⁄(1 + 0.02)
𝑖𝑖 ′ = 3.4%
Bank pays 5.5% interest compounded annually.
Inflation is expected at 8%. Identify 𝑖𝑖, 𝑓𝑓, 𝑖𝑖𝑖
𝑖𝑖 = 5.5%; 𝑓𝑓 = 8%
1 + 𝑖𝑖 ′ = 1 + 0.055 ⁄(1 + 0.08)
𝑖𝑖 ′ = −2.3%
Copyright Oxford University Press 2014
 Actual Dollars and Real Dollars
Definitions
• Actual dollars (𝑨𝑨𝑨): cash money – circulating dollars
(also called inflated dollars)
• Real dollars (𝑹𝑹𝑹): dollars with constant purchasing
power and always expressed as a “base” year (also
called constant dollars, constant purchasing power
dollars, or inflation-free dollars)
• Use a market interest rate (𝑖𝑖) when dealing with 𝐴𝐴𝐴
• Use a real interest rate (𝑖𝑖𝑖) when dealing with 𝑅𝑅𝑅

𝑓𝑓 for 0 R$ base (𝑡𝑡) at (t) i’ 𝑅𝑅𝑅 base (t) at (𝑛𝑛) 𝑓𝑓 for 𝑛𝑛 − 𝑡𝑡

period 𝐴𝐴𝐴 at (𝑡𝑡) i 𝐴𝐴𝐴 at (𝑛𝑛) periods

𝑡𝑡 𝑛𝑛
Copyright Oxford University Press 2014
 Example 14-2
Real Interest Rate Calculation
A stadium was built in 1960 at $1.2 million. At the same year, a
gift of the same amount was invested at a market rate 8.0% per
year. Inflation is 6.0% from 1960 to 2015. Define 𝑖𝑖, 𝑓𝑓, 𝑖𝑖𝑖, 𝐴𝐴𝐴, 𝑅𝑅𝑅
𝑖𝑖 = 8.0%; 𝑓𝑓 = 6.0%
1 + 𝑖𝑖 ′ = 1 + 0.08 ⁄(1 + 0.06) 𝑖𝑖 ′ = 1.887%
The building’s cost in 1960 was $1,200,000, which were the
actual dollars (A$) spent in 1960.
How much actual dollars the gift will worth in 2015?
𝐴𝐴𝐴2015 = 𝐴𝐴𝐴1960 𝐹𝐹 ⁄𝑃𝑃, 𝑖𝑖, 55) = $1,200,000(𝐹𝐹 ⁄𝑃𝑃, 8%, 55
= $82,701,600

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 Example 14-2
Real Interest Rate Calculation
How much the gift will worth in 2015 in terms of 1960
purchasing power?
𝑅𝑅𝑅𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏 1960 𝑎𝑎𝑎𝑎 2015 = 𝑅𝑅𝑅𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏 1960 𝑎𝑎𝑎𝑎 1960 𝐹𝐹 ⁄𝑃𝑃 , 𝑖𝑖 ′ , 55
= $1,200,000(𝐹𝐹 ⁄𝑃𝑃 , 1.887%, 55) = $3,357,000; or
𝐴𝐴𝐴2015 $82,701,600
𝑅𝑅𝑅𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏 1960 𝑎𝑎𝑎𝑎 2015 = 55
= 55
= $3,357,000
(1 + 𝑓𝑓) (1 + 0.06)
If the gift will be used to build a new stadium in 2015. How
much better or worse the new stadium be?
𝑅𝑅𝑅𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏 1960 𝑎𝑎𝑎𝑎 2015 $3,357,000
= = 2.8
𝑅𝑅𝑅𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏 1960 𝑎𝑎𝑎𝑎 1960 $1,200,000

Copyright Oxford University Press 2014

 Example 14-3
Real Interest Rate Calculation
$1000 worth of quarters were buried in the backyard in 1924.
Average Inflation was 4.5% from 1924 to 1994. What was
the relative purchasing power of these quarters?
𝐴𝐴𝐴1994 $1000
𝑅𝑅𝑅𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏 1924 𝑎𝑎𝑎𝑎 1994 = 70
= 70
= $45.90
(1 + 𝑓𝑓) (1 + 0.045)

If $1000 was invested in stock market in 1924, how much it

will worth in 1994 given that the stock market increased an
average of 15%?
𝐴𝐴𝐴1994 = 𝐴𝐴𝐴1924 𝐹𝐹 ⁄𝑃𝑃, 𝑖𝑖, 70) = $1,000(𝐹𝐹 ⁄𝑃𝑃, 15%, 70
= $17,735,000
𝐴𝐴𝐴1994 $17,735,000
𝑅𝑅𝑅𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏 1924 𝑎𝑎𝑎𝑎 1994 = 70
= 70
= $814,069
(1 + 𝑓𝑓) (1 + 0.045)
Copyright Oxford University Press 2014
 Example 14-3
Real Interest Rate Calculation
If $1000 was invested in government bonds in 1924, how
much it will worth in 1994 given that the bonds averaged 6%
return per year?
𝐴𝐴𝐴1994 = 𝐴𝐴𝐴1924 𝐹𝐹 ⁄𝑃𝑃, 𝑖𝑖, 70) = $1,000(𝐹𝐹 ⁄𝑃𝑃, 6%, 70 = $59,076
𝐴𝐴𝐴1994 $59, 076
𝑅𝑅𝑅𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏 1924 𝑎𝑎𝑎𝑎 1994 = 70
= 70
= $2,712
(1 + 𝑓𝑓) (1 + 0.045)

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 Analysis in Constant Dollars (𝑅𝑅𝑅)
versus Then-Current Dollars (𝐴𝐴𝐴)
Analysis in Constant Dollars (𝑹𝑹𝑹)
• Ignoring inflation in the analysis
• Most costs and benefits have prices increase at
about the same rate as general inflation
• Use real dollars (𝑅𝑅𝑅) and a real interest rate (𝑖𝑖𝑖)

Analysis in Then-Current Dollars (𝑨𝑨𝑨)

• Incorporating inflation in the analysis
• Use actual dollars (𝐴𝐴𝐴) and a market interest rate
(𝑖𝑖)

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 Example 14-4
R$ Analysis versus A$ Analysis
Constant Dollar Analysis:
Company Alpha Beta
Year 𝐴𝐴𝐴 𝑅𝑅𝑅 𝑅𝑅𝑅
1 150,000 150,000/(1.035)=$144,928 150,000
2
2 150,000(1.05) 150,000(1.05)/(1.035) =147,028 150,000
2 2 3
3 150,000(1.05) 150,000(1.05) /(1.035) =149,159 150,000
3 3 4
4 150,000(1.05) 150,000(1.05) /(1.035) =151,321 150,000
4 4 5
5 150,000(1.05) 150,000(1.05) /(1.035) =153,514 150,000
1 + 𝑖𝑖 ′ = (1 + 0.25)/(1 + 0.035) ∴ 𝑖𝑖 ′ = 20.8%
𝑃𝑃𝑃𝑃(𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐)𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 = $436,000
𝑃𝑃𝑃𝑃(𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐)𝐵𝐵𝐵𝐵𝐵𝐵𝑎𝑎 = $441,000

Copyright Oxford University Press 2014

 Example 14-4
R$ Analysis versus A$ Analysis
Then-Current Dollar Analysis:
Company Beta Alpha
Year R$ A$ A$
1 150,000 150,000(1.035)=$155,250 $150,000
2
2 150,000 150,000(1.035) =160,684 150,000(1.05)=157,500
3 2
3 150,000 150,000(1.035) =166,308 150,000(1.05) =165,375
4 3
4 150,000 150,000(1.035) =172,128 150,000(1.05) =172,128
5 4
5 150,000 150,000(1.035) =178,153 150,000(1.05) =178,153
𝑖𝑖 = 25%
𝑃𝑃𝑃𝑃(𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐)𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 = $436,000
𝑃𝑃𝑃𝑃(𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐)𝐵𝐵𝐵𝐵𝐵𝐵𝑎𝑎 = $441,000

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 Example 14-5
R$ Analysis versus A$ Analysis
Year
A new heat exchanger will R$ A$
cost $220,000, and it will 0 $ (220,000.00) $ (220,000.00)
save $50,000 annually. 1 $ 50,000.00 $ 52,500.00
After 10 years it will have 2 $ 50,000.00 $ 55,125.00
no salvage value. The 3 $ 50,000.00 $ 57,881.25
firm’s real interest rate is 4 $ 50,000.00 $ 60,775.31
15%. If inflation is 5%, is 5 $ 50,000.00 $ 63,814.08
this project worth doing? 6 $ 50,000.00 $ 67,004.78
Analyze in A$ and R$. 7 $ 50,000.00 $ 70,355.02
8 $ 50,000.00 $ 73,872.77
′ ′ 9 $ 50,000.00 $ 77,566.41
𝑖𝑖 = 𝑖𝑖 + 𝑓𝑓 + 𝑖𝑖 𝑓𝑓 10 $ 50,000.00 $ 81,444.73
= 15% + 5% + 15% 5% MARR 15.00% 20.75%
= 20.75% NPW $ 30,938.43 $ 30,938.43

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 Price Change with Indexes

• Price Indexes describe relative price fluctuation of

goods and services.
• Price Indexes are tracked for a specific commodity
or for bundles (composites) of commodities.
• We use past price changes to predict future prices
• All price indexes have a “base year”, which is
assigned a value of 100.
𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑡𝑡
𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝑡𝑡 = × 100
𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵 𝑦𝑦𝑦𝑦𝑦𝑦𝑦𝑦

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 Price Changes in Postage

• Letter Cost Index (LCI) describe relative price

fluctuation of sending a first-class letter in the U.S.
• Base year = 1970. LCI1970 = 100
𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑛𝑛
𝐿𝐿𝐿𝐿𝐿𝐿𝑦𝑦𝑦𝑦𝑦𝑦𝑦𝑦 𝑛𝑛 = × 100 (14-2)
𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐1970

𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐1980 0.15
𝐿𝐿𝐿𝐿𝐿𝐿1980 = × 100 = × 100 = 250
𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐1970 0.06

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 Price Changes in Postage

0.5
0.45
0.4
0.35
0.3
0.25
0.2
0.15
0.1
0.05
0
1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015 2020

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 Price Change with Indexes

• Annual percentage increase

𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝑡𝑡 − 𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝑡𝑡−1
𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 % 𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝑡𝑡 = × 100% (14-3)
𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝑡𝑡−1

• Average rate of price increase

1
𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝑡𝑡𝑡 (𝑡𝑡𝑡−𝑡𝑡𝑡)
𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 % 𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝑡𝑡𝑡−𝑡𝑡𝑡 = − 1 × 100%
𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝑡𝑡𝑡

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 Example 14-6
Price Change with Indexes
A new building in L.A. cost was $5.25 million in 2000.
How much will it cost in 2015?
California Construction Cost Index (CCCI)2000 = 3746
CCCI2010 = 5260
1
𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶2010 10
𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 % 𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼2000−2010 = − 1 × 100% = 3.45%
𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶2000

𝐴𝐴𝐴2015 = 𝐴𝐴𝐴2000 (1 + 𝑓𝑓)15 = $5.25 𝑀𝑀 (1.0345)15 = $8.73 𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚

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 Composite Cost Index:
Consumer Price Index (CPI)
CPI Inflation Rates (%)
16
14
12
10
8
6
4
2
0
1970 1975 1980 1985 1990 1995 2000 2005 2010 2015
-2
Source: ftp://ftp.bls.gov/pub/special.requests/cpi/cpiai.txt
Copyright Oxford University Press 2014
 Example 14-8
Different Inflation Rates per Period
Year 1-5, Inflation rate = 5%, Real interest rate = 10%
1 + 𝑖𝑖 = 1 + 𝑖𝑖 ′ 1 + 𝑓𝑓 = 1 + 10% 1 + 5% ∴ 𝑖𝑖 = 11.50%

Year 6-8, Inflation rate = 7.5%, Real interest rate = 10%

1 + 𝑖𝑖 = 1 + 𝑖𝑖 ′ 1 + 𝑓𝑓 = 1 + 10% 1 + 7.5% ∴ 𝑖𝑖 = 18.25%

Year 9-13, Inflation rate = 3%, Real interest rate = 10%

1 + 𝑖𝑖 = 1 + 𝑖𝑖 ′ 1 + 𝑓𝑓 = 1 + 10% 1 + 3% ∴ 𝑖𝑖 = 13.30%

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 Example 14-9 Inflation Effect on
After-tax Calculation
Inflation rate = 0%
Year BTCF SL Depr. Taxable Tax ATCF(A$) ATCF(R$)
0 -$12,000.00 -$12,000.00 -$12,000.00
1 $2,918.00 $2,000.00 $918.00 $422.28 $2,495.72 $2,495.72
2 $2,918.00 $2,000.00 $918.00 $422.28 $2,495.72 $2,495.72
3 $2,918.00 $2,000.00 $918.00 $422.28 $2,495.72 $2,495.72
4 $2,918.00 $2,000.00 $918.00 $422.28 $2,495.72 $2,495.72
5 $2,918.00 $2,000.00 $918.00 $422.28 $2,495.72 $2,495.72
6 $2,918.00 $2,000.00 $918.00 $422.28 $2,495.72 $2,495.72
IRR 11.99% 6.72% 6.72%

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 Example 14-9 Inflation Effect on
After-tax Calculation
Inflation rate = 5%
Year BTCF SL Depr. Taxable Tax ATCF(A$) ATCF(R$)
0 -$12,000.00 -$12,000.00 -$12,000.00
1 $3,063.90 $2,000.00 $1,063.90 $489.39 $2,574.51 $2,451.91
2 $3,217.10 $2,000.00 $1,217.10 $559.86 $2,657.23 $2,410.19
3 $3,377.95 $2,000.00 $1,377.95 $633.86 $2,744.09 $2,370.45
4 $3,546.85 $2,000.00 $1,546.85 $711.55 $2,835.30 $2,332.61
5 $3,724.19 $2,000.00 $1,724.19 $793.13 $2,931.06 $2,296.56
6 $3,910.40 $2,000.00 $1,910.40 $878.78 $3,031.62 $2,262.24
IRR 17.59% 10.18% 4.94%

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 Example 14-10 Using Spreadsheet
for Inflation Calculation
General Inflation rate = 3%, Labor costs increase at 6%,
Transportation costs increase at 5%, Real interest rate = 7%
Market interest rate = (1+7%)(1+3%)-1 =10.21%
Transportation Transportation
Year Labor (A$) (R$) (A$) Total (A$) Total (R$)
1 $120,000.00 $40,000.00 $42,000.00 $162,000.00 $157,281.55
2 $127,200.00 $60,000.00 $66,150.00 $193,350.00 $182,250.92
3 $134,832.00 $50,000.00 $57,881.25 $192,713.25 $176,359.92
4 $142,921.92 $30,000.00 $36,465.19 $179,387.11 $159,383.12
PW $571,731.97 $571,731.97
EUAC $181,185.33 $168,791.35

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 Example 14-11 Inflation Effect on
After-tax Calculation
Inflation rate = 0%
MACRS
Year BTCF Depr. Taxable Tax ATCF(A$) ATCF(R$)
0 -$12,000.00 -$12,000.00 -$12,000.00
1 $2,918.00 $2,400.00 $518.00 $238.28 $2,679.72 $2,679.72
2 $2,918.00 $3,840.00 -$922.00 -$424.12 $3,342.12 $3,342.12
3 $2,918.00 $2,304.00 $614.00 $282.44 $2,635.56 $2,635.56
4 $2,918.00 $1,382.00 $1,536.00 $706.56 $2,211.44 $2,211.44
5 $2,918.00 $1,382.00 $1,536.00 $706.56 $2,211.44 $2,211.44
6 $2,918.00 $691.00 $2,227.00 $1,024.42 $1,893.58 $1,893.58
IRR 11.99% 7.29% 7.29%

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 Example 14-11 Inflation Effect on
After-tax Calculation
Inflation rate = 5%
MACRS
Year BTCF Depr. Taxable Tax ATCF(A$) ATCF(R$)
0 -$12,000.00 -$12,000.00 -$12,000.00
1 $3,063.90 $2,400.00 $663.90 $305.39 $2,758.51 $2,627.15
2 $3,217.10 $3,840.00 -$622.91 -$286.54 $3,503.63 $3,177.90
3 $3,377.95 $2,304.00 $1,073.95 $494.02 $2,883.93 $2,491.25
4 $3,546.85 $1,382.00 $2,164.85 $995.83 $2,551.02 $2,098.73
5 $3,724.19 $1,382.00 $2,342.19 $1,077.41 $2,646.78 $2,073.82
6 $3,910.40 $691.00 $3,219.40 $1,480.92 $2,429.48 $1,812.91
IRR 17.59% 10.96% 5.68%

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