Effects of Inflation

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
• todays dollars future dollars
• (1f)n
• future dollars todays 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
• (1f)25
• f 5.7
• Using fast-food as a basis, the inflation rate
  over the 25 year period 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 _______________
• PW ___________________________
• Find the PW assuming a 6 annual inflation rate,
  compounded quarterly.
• if ___________________________
• PW ___________________________________________

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.
• Example 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 ________________________
• A _________________________