ENGR 3360U Winter 2014

Unit 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

17-2

2013-IV-01

Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco

Unit 14 Inflation again!

Course Outline
1.
2.

3.
4.
5.
6.
7.
8.
9.
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Engineering Economics
General Economics
1.
Microeconomics
2.
Macroeconomics
3.
Money and the Bank of
Canada
Engineering Estimation
Interest and Equivalence
Present Worth Analysis
Annual Cash Flow
Rate of Return Analysis
Picking the Best Choice
Other Choosing Techniques
2013-IV-01

10. Uncertainty and Risk

11. Income and Depreciation
12. After-tax Cash Flows
13. Replacement Analysis
14. Inflation
15. MARR Selection
16. Public Sector Issues
17. What Engineering should know
about Accounting
18. Personal Economics for the
Engineer

Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco

Unit 14 Inflation again!

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

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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

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Inflation
Inflation depends on:

Money supply

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

If there is too much money in the system in relation to goods and

services, the value tends to decrease.

Producers of goods and services push the cost of increasing

operating costs to consumers.

Demand-pull

More demand (exceeding supply) tends to increase prices.

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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 ratebecause it includes both inflation and real
interest)

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14.2 Rates and Dollars

Mathematical relationship for market rate:
i = i + f + if

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)

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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?

17-9

2013-IV-01

Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco

Unit 14 Inflation again!

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

17-10

2013-IV-01

Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco

Unit 14 Inflation again!

Relationships

Shows the relationship between A$ and R$

when these occur in the same period of
time.

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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.

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14.4 Price Change Indexes

Comparing 2008-based dollars with 2010based dollars is like comparing apples and
oranges.

They dont 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

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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

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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.

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

Unit 14 Inflation again!

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 + if

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Summary, contd.
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.