INFLATION

1. INFLATION • Prices of all goods and services change over time • An increase in average prices over time is called inflation • A decrease in average prices over time is called deflation • Prices are likely to change over the life of an engineering project due to inflation or deflation JK Higginson: Engineering Economics

2. NOMINAL AND REAL DOLLARS Nominal Dollars: dollars at the time that cash flows occur • These are the ones in our pockets, and recorded in our bank books, cheque books, accounting records • The purchasing power of these changes due to inflation/deflation • Also as known as current or actual dollars Real Dollars: dollars of constant purchasing power • These are a hypothetical unit of measure • Always need a reference date (usually called the “base year”) • The base year need not be the current year • Also as known as constant dollars JK Higginson: Engineering Economics

3. USES OF PRICE INDICES IN ENGINEERING PROJECTS • Contract Escalation • A mining company entering a long-term equipment purchase contract with a major distributor wants to establish guidelines which will govern the future prices of the equipment it buys. • Using the Mining, Quarrying and Ore dressing Machinery Index, the company ties the future price increases of equipment to those of the index. • Tracking Selling Prices • A pharmaceutical firm wants to compare price changes for its products with those of the industry as a whole. • Using a series of Pharmaceutical Indexes, analysts can compare their price trends over time with those of the industry. In this way, they can get a sense of their own competitiveness. JK Higginson: Engineering Economics

4. CONVERSION BETWEEN ACTUAL AND REAL DOLLARS If we have an estimate of the inflation rate per period over N periods, we can convert actual dollars in period N to real dollars. AN = actual dollars in year N R0,N = real dollars equivalent to AN relative to year 0 (the base year) f = the inflation rate per year (assumed to be constant from year 0 to yearN) JK Higginson: Engineering Economics

5. Then the conversion from actual dollars in year N to real dollars in year N relative to the base year 0 is: The base year (0) is usually omitted from the notation: This can conveniently be written and computed with the Present Worth Factor: RN = AN(P/F, f, N) RN is real dollars at time N and not a present worth JK Higginson: Engineering Economics

6. NOMINAL AND REAL INTEREST RATES The real interest rate, i’, is the interest rate that would yield the same number of real dollars in the absence of inflation as the actual interest rate yields in the presence of inflation. From nominal to real: From real to actual: i = i’ + f + i’f JK Higginson: Engineering Economics

7. ACTUAL AND REAL MARRS If investors expect inflation, they will require higher actual rates of return on their investments than if no inflation was expected. MARRactual = MARRreal + f + MARRreal f JK Higginson: Engineering Economics

8. ECONOMIC EVALUATION WITH INFLATION Method 1: Work with real cash flows and find the real MARR using an estimate of f. Method 2: Adjust the real cash flows for inflation; ie., get estimates of the actual cash flows using f, and apply the actual MARR. JK Higginson: Engineering Economics