CIVL 4050

Winter 2016

Module 10: Inflation

Reference:
Newnan, D., Whittaker, J., Eschenbach, T., and Lavelle, J. (2014). Engineering Economic Analysis (3rd
Canadian edition). Oxford University Press.
Learning Objectives
Describe inflation, explain how it happens and its effects on purchasing power
Define real/ constant and actual/ current dollars and interest rates and conduct relevant analyses
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

Inflation depends on:

Money supply
If there is too much money in system in relation to goods and services, value
tends to decrease
Exchange rates
Strength of dollar in world markets subsequently changes its value because (for
example) corporations will increase prices to make up for loss in world market
value
Cost-push
Producers of goods and services push the cost of increasing operating costs to
consumers
Demand-pull
More demand (exceeding supply) tends to increase prices

Inflation rate (f)

Annual rate of increase in number of dollars needed to pay for same goods and services
Captures decrease in purchasing power
Real Interest rate (i)
Measures real growth of money, excluding effect of inflation (inflation-free rate)
Captures increase in purchasing power
Market Interest rate (i)
Rate obtained in general marketplace (combined rateincludes both inflation and real
interest)
e.g. interest rates on savings accounts, chequing accounts and term deposits quoted at
bank
Mathematical relationship for market rate:
i = i + f + if

Actual dollars:
What we normally think of when we think of money
We can touch these dollars and keep them in purses and wallets!
Exist physically
Sometimes called current, then-current or inflated dollars because they carry inflation
effect (decreased purchase power)
Real dollars
Constant dollars that represent purchasing power of base year (inflation-free dollars), e.g.
2008-based dollars
Sometimes called constant dollars or inflation-free dollars because they do not carry
inflation effect

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Figure 1: Relationship between i, f, i, A$ and R$

When dealing with actual dollars (A$), use market interest rate (i) and when discounting A$ over
time, also use i.
When dealing with real dollars (R$), use real interest rate (i) and when discounting R$ over time,
also use i.
Actual and real dollars that occur at same time are related by inflation rate.

Analysis
Two ways to approach economic analysis:
Ignoring Inflation (constant/ real dollars using i)
Incorporating Inflation (current/ actual dollars using the market rate i)
Constant/ Real Dollars versus Current/ Actual Dollars
Preferable not to combine two types in same problem
Example #1
Problem
Suppose Tiger Woods wants to invest some recent gold winnings that are worth $1,000 in his hometown
bank for one year. Currently, the bank is paying a rate of 5.5% a year. Assume inflation is expected to be
2% a year. Identify i, f, and i. If he was buying golf balls for $5 each today, how many balls can he
purchase at the end of the year?
Solution

Thus, Tiger Woods will have 3.4% more purchasing power than he had a year ago.
At the beginning of the year:

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Winter 2016

At the end of the year:

Thus, Tiger Woods can, after one year, buy 3.4% more golf balls than he could before.
Example #2
Problem
The kitchen manager of a restaurant has asked Elvis to estimate the equivalent total annual cost of
introducing lima beans and corn to the buffet line over the next 5 years. Elvis has used his knowledge of
these two crops and estimated the following data:
Costs for lima beans will inflate at 3% per year for the next 3 years and then at 4% for the
following 2 years.
Costs for corn will inflate at 8% per year for the next 2 years and then decrease 2% in the
following 3 years.
Current annual costs of lima beans and corn are $5,460 and $12,480 respectively. Assume an MARR of
20%.
Solution

Example #3
Problem
When the university stadium was completed in 1955, its total cost was $1.2 million. At that time, a wealthy
alumnus made the university a gift of $1.2 million to be used for a future replacement. University
administrators are now considering building a new stadium in the year 2010. Assume that:

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Inflation is 6% per year from 1995 to 2010.

In 1955 the university invested the gift at a market interest rate of 8% per year.

(a) Define i, i, and A$.

(b) How many actual dollars in the year 2010 will the gift be worth?
(c) How much would the actual dollars in 2010 be in terms of 1995 purchasing power? How much
better or worse would the new stadium be?
Solution
(a) i = 8%,

The cost of the building in 1955 was $1,200,000. These were the actual dollars (A$) spent in 1995.
(b) We are going from actual dollars in 1955 to actual dollars in 2010. To do so, we must use the
market interest rate and compound this amount forward 55 years.

(c) Translate the actual dollars in 2010 to real 1955 dollars in 2010. Use the inflation rate to strip 55
years of inflation from the actual dollars. We do this by using the P / F factor for 55 years at the
inflation rate. We are not physically moving the dollars in time; rather we are simply removing
inflation from these dollars one year at a time.

A different way of doing this is to translate the real 1955 dollars in 1955 to real 1955 dollars in 2010. To
do so, use the real interest rate.

As the amount available for the new project in terms of 1955 dollars is almost $3.4 million, the new
stadium will be about 3.4/1.2 or approximately 2.8 times better than the original one using real dollars.
Example #4
Problem
A corporation is interested in evaluating two proposals to develop a new technology over a five-year
period:
Company Alpha costs: Development costs will be $150,000 the first year and will increase at a
rate of 5% over the five year-period.
Company Beta costs: Development costs will be a constant $150,000 per year in terms of todays
dollars over the five-year period.

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Assuming a MARR of 25% and an inflation rate of 3.5%, which alternative should the corporation select?
Solution
Inflate the stated yearly cost given by Company Alpha by 5% per year to obtain the then-current (actual)
dollars each year. Company Betas costs are given in terms of today-based constant dollars.

Using a constant dollar analysis:

Here, we must convert the then-current costs given by Company Alpha to constant today-based dollars.
We do this by stripping the right number of years of general inflation from each years cost using (P/F, f,
n) or (1+f)-n.

We then use the real interest rate i to calculate the present worth of costs for each alternative:

Using a then-current dollar analysis:

We must convert the constant dollar costs of Company Beta to then-current dollars. We do this by using
(F/P, f, n) or (1+f)n to add in the appropriate number of years of general inflation to each years cost.

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Using the market interest rate i, calculate the present worth of costs for each alternative.

Using either a constant-dollar or then-current dollar analysis, the company should chose Company
Alphas offer because it has the lower present worth of costs.

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