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Effects of Inflation

Learn about the impact of inflation on interest rates and financial calculations. Explore examples and cases to grasp inflation's influence on present and future financial values. Understand how inflation affects capital recovery analysis.

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Effects of Inflation

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  1. Effects of Inflation Inflation – the increase in the amount of money necessary to obtain the same amount of product or service before the inflated prices was present. Let f represent the inflation rate per period (year), then for n periods in the future: today’s dollars = future dollars (1+f)n future dollars = today’s dollars (1+ f)n

  2. Effects of Inflation Example 1978 – hamburger, coke and fries ($0.99). 2003 - hamburger, coke and fries ($3.99). $0.99 = $3.99 (1+f)25 f = 5.7% Using fast-food as a basis, the inflation rate over the last 25 years was 5.7%.

  3. Effects of Inflation Definitions Real or inflation-free interest rate (i) – the rate at which interest is earned without considering the effects of changes in the value of currency. Inflation adjusted interest rate if– the interest rate that has been adjusted to take inflation into account (the market interest rate). This rate is a combination of the real interest rate (i) and the rate of inflation (f). Note: when you place money in a bank, the bank is paying a market interest rate.

  4. Effects of Inflation Present Worth Adjusted for Inflation Recall PW given some Future value: If F is a future-dollar amount with inflation built in, then: or, where,

  5. Effects of Inflation Example A 10-year, $10,000 bond with a 10% dividend rate paid quarterly, is expected to return 8% per year, compounded quarterly. Find the PW assuming no inflation. I = 2.5% * $10,000 = $250. PW = $250(P/A,2%,40) + $10,000(P/F,2%,40) = $11367 Find the PW assuming a 6% annual inflation rate, compounded quarterly. if = 2% + 6%/4 +2.5%(6%/4) = 3.53% PW = $250(P/A,3.53%,40) + $10,000(P/F,3.53%,40) = $7875

  6. Effects of Inflation Future Worth Case 1: Actual Amount Accumulated – when trying to determine the actual amount of accumulated money after some time period, use the market interest rate. or

  7. Effects of Inflation Future Worth Case 2: Constant value with purchasing power – to determine the purchasing power of future dollars, first calculate the future dollar value using if , then discount the effects of inflation. or

  8. Effects of Inflation Future Worth Case 3: Future amount required, no interest – this is the case when one wants to know the future cost of an item, such as a hamburger, fires and coke. or,

  9. Effects of Inflation Future Worth Case 4: Inflation and Real Interest – this is the case when a MARR is established that accounts for a desired earned interest rate, and also account for inflation. If an interest of i is desired, and inflation is running at a rate of f, then the MARRf is set to: MARRf = if = i + f + if or,

  10. Effects of Inflation Capital Recovery Because capital recovery analysis tends to span a significant number of years, the effects of inflation are particularly important. A toll bridge is built for $20 million. How much must be recovered in tolls if the bridge is to last for 20 years. Assume a MARR of 4% and an inflation rate of 3%. if = .04 + .03 + .04*.03 = 7.12% A = $20,000,000(A/P,7.12%,20)

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