Types of Analysis Method Market Interest rate (i) Inflation-free interest rate (i') In Constant Dollars In Actual Dollars Constant Dollar Analysis Actual Dollar Analysis Deflation Method Adjusted-discount method 3 $1,260 (1 + 0.08) = $1,000 Conversion from Actual to Constant Dollars $1,260 $1,000 3 3 Actual Dollars Constant DollarsĮxample 4.4 Conversion from Actual to Constant DollarsĮquivalence Calculation Under Inflation 1. We will assume that the base year is always time zero unless we specify otherwise.ģ $1,000 (1 + 0.08) = $1,260 Conversion from Constant to Actual Dollars $1,260 $1,000 3 3 Actual Dollars Constant DollarsĮxample 4.3 Conversion from Constant to Actual Dollars Constant (real) Dollars (A'n): Represents constant purchasing power independent of the passage of time.Usually, these amounts are determined by applying an inflation rate to base-year dollar estimates. Actual Dollars (An ): Estimates of future cash flows for year n that take into account any anticipated changes in amount caused by inflationary or deflationary effects.Inflation Terminology – IIThe effect of inflation into economic analysis The average inflation rate over 3 years is General Inflation Rate ( f ) Average inflation rate based on the CPIĮxample 4.2: Yearly and Average Inflation Rates What are the annual inflation rates and the average inflation rate over 3 years? Solution Inflation rate during year 1 (f1): ($538,400 - $504,000) / $504,000 = 6.83%. $100 ( 1 + 0.04) ( 1 + 0.08) = $112.32 Step 2: Find the average inflation rate by solving the following equivalence equation. $112.32 0đ 2 $100 Average Inflation Rate (f ) Fact: Base Price = $100 (year 0) Inflation rate (year 1) = 4% Inflation rate (year 2) = 8% Average inflationrate over 2 years? Step 1: Find the actual inflated price at the end of year 2. This reference period is designated as the base period. Measuring Inflation Consumer Price Index (CPI):the CPI compares the cost of a sample “market basket” of goods and services in a specific period relative to the cost of the same “market basket” in an earlier reference period. General Inflation Rate ( f): the average inflation rate calculated based on the CPI for all items in the market basket. Consumer Price Index (CPI): a statistical measure of change, over time, of the prices of goods and services in major expenditure groups-such as food, housing, apparel, transportation, and medical care - typically purchased by city consumers Average Inflation Rate ( f ): a single rate that accounts for the effect of varying yearly inflation rates over a period of several years. Its components are broken down by industry sector, product. Producer Price Index (PPI): a statistical measure of wholesale industrial price change, compiled monthly by the BLS, to evaluate wholesale price levels in the economy. 20.38% $1.57 / gallon $1.25 / gallon Price change due to deflation You can now purchase 80 gallons of unleaded gas. $100 $100 -2 -1 0 1 -2 -1 0 1 You could purchase 63.69 gallons of unleaded gas a year ago. 25% $2.00 / unit $2.50 / unit Price change due to inflation The $100 in year 2003 has only $80 worth purchasing power of 1990 You can only buy 40 Big Macs in year 2003.
Using the equation above, Ahmed’s true earning power is only $3.85 per hour! He usually wake up at 6:30 AM to get ready for work, and return home around 6:30 PM each day totaling about 12 hours per day, 60 hours per week, or approximately 260 hours per month. His taxes and living expenses total $4,000 a month. For example: Ahmed makes $5,000 a month.True Earning Power = (Monthly Income - Monthly Taxes and Necessity Expenses) / Time.
Decrease in purchasing power (inflation) Increase in Purchasing Power (deflation) Purchasing power The value of a currency expressed in terms of the amount of goods or services that one unit of money can buy.
Purchasing Power Earning Power How much you currently make at your place of employment plays a major part in your earning power.Inflation means that the cost of an item tends to increase over time, or the same dollar amount buys less of an item over time. What is Inflation? A loss in the purchasing power of money over time. How do we incorporate theeffect of inflationin equivalence calculation?.
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