ME 291

Engineering Economy
Lecture 25
Effect of Inflation – Chapter 14

Faculty of Mechanical Engineering

Ghulam Ishaq Khan Institute, Topi, Swabi

ENGINEERING
ECONOMY
Impact of Inflation

• Inflation is an increase in the amount of

money necessary to obtain the same
amount of product or service before the
inflated price was present.
• Deflation is the opposite of inflation.

ENGINEERING
ECONOMY
Formulae
• Money in one period of time t1 can be brought to the same
value as money in another period of time t2 by using the
equation.

• Dollars in period t1 are called constant-value dollars or

today’s dollars. Dollars in period t2 are called future dollars.
If f represents the inflation rate per period (year) and n is
the number of time periods (years) between t1 and t2, then

ENGINEERING
ECONOMY
Types of Interest Rates

• Real or inflation-free interest rate I

when there is no inflation involved
• Inflation-adjusted interest rate if
interest rate in which inflation has been taken into
account. Also called inflated interest rate.

ENGINEERING
ECONOMY
PW calculations adjusted for inflation

• When the dollar amounts in different periods are

expressed in constant value dollars, the equivalent
present and future amounts are determined using the
real interest rate i.
• For example $5000 with an inflation rate of 4% will
become 5000(1.04)4 = 5849 after 4 years. But if the
constant value of these dollars is found out at that time
by 5849/(1.04)4 = 5000 then the present worth can be
found by applying simple interest rate.
• If the value is not converted to constant value dollars
then the present worth calculation has got a modified
formulae.

ENGINEERING
ECONOMY
PW calculation (Contd….)
• We know that

• With inflation rate f involved the formulae can be modified to

or

Where if = i + f + if

ENGINEERING
ECONOMY
Example 14.1

ENGINEERING
ECONOMY
Example 14.2
• A 15-year $50,000 bond has a dividend rate of 10% per
year, payable semiannually, is currently for sale. If the
expected rate of return of the purchaser is 8% per year,
compounded semiannually, and if the inflation rate is
expected to be 2.5% each of 6-month period, what is the
bond worth now (a) without an adjustment for inflation
and (b) when inflation is considered?

ENGINEERING
ECONOMY
Example 14.3
• A self-employed chemical engineer is on
contract with Dow Chemical, currently working
in a relatively high-inflation country. He wishes
to calculate a project’s PW with estimated cost
of $35,000 now and $7000 per year for 5 years
beginning 1 year from now with increase of
12% per year thereafter for the next 8 years.
Use a real interest rate of 15% per year to
make the calculations (a) without an
adjustment for inflation and (b) considering
inflation at a rate of 11% per year.

ENGINEERING
ECONOMY