Ise431 L5 1

Meaning and Measure of
Inflation
Inflation and Economic
Analysis
 What is inflation?
 How do we measure inflation?
 How do we incorporate the effect of
inflation in
equivalence calculation?
What is Inflation?
Inflation is the rate at which the general level of prices and goods and
services is rising, and subsequently, purchasing power is falling.
 Time Value of Money

Earning Power
Purchasing power
 Earning Power
Investment Opportunity
 Purchasing Power
Decrease in purchasing power (inflation)
Increase in purchasing Power (deflation)
Purchasing Power
$100 $100
1990 1990 2008
You could buy 50 Big Macs You can only buy 28.5 Big
in year 1990. Macs in year 2008.
$2.00 / unit 75%

Price change
$3.50 / unit
due to
inflation
The $100 in year 2008 has only $57
worth purchasing power of 1990
Deflation
$100 $100
2005 2006 2007 2008 2005 2006 2007 2008
You could purchase You can now purchase

63.69 gallons of purified 80 gallons of purified
drinking water in 2006 drink water in 2007
20.38%
$1.57 / gallon $1.25 / gallon
Price change due to
deflation
Inflation Terminology - I
 Producer Price Index: a statistical measure of industrial price
change, compiled monthly by the Bureau of Labor Statistics, U.S.
Department of Labor
 Consumer Price Index: 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 urban consumers
 Average Inflation Rate (f): a single rate that accounts for the
effect of varying yearly inflation rates over a period of several years.
 General Inflation Rate (f ): the average inflation rate
calculated based on the CPI for all items in the market basket.
Consumer Price Index
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. This reference period is designated
as the base period.
2009
638.8
213.2
Various Cost Components that
Affect the Retail Gasoline Price
Selected Price Indexes
between 1997 and 2006
Average Inflation Rate (f )
Fact:
Base Price = $100 (year 0)
Inflation rate (year 1) = 4%
Inflation rate (year 2) = 8%
Average inflation rate over 2 years?
Step 1: Find the actual inflated price at the end of year 2.
$100 ( 1 + 0.04) ( 1 + 0.08) = $112.32
Step 2: Find the average inflation rate by solving the

$112.32
following equivalence equation.
2 0 1
$100 ( 1+ f) = $112.32 2
f = 5.98% $100
Example 4.1 Calculating an
Average Inflation Rate
General Inflation Rate (f )
Average inflation rate based on the CPI

Example 4.2: Yearly and Average
Inflation Rates
Year Cost
What are the annual inflation rates
2000 $168.82
and the average inflation rate over 6 years?
2001 209.44
2002 228.73
2003 238.75 Solution
2004 263.09
Inflation rate between 2000 and 2001 (f1):
2005 276.24
($209.44 - $162.82) / $162.82 = 24.52%.
2006 287.84 Inflation rate between 2001 and 2002 (f ):
2
2007 ? ($228.73 - $209.44) / $209.44 = 9.21 %.

Inflation rate between 2002 and 2003 (f ):
3
($238.75 - $228.73) / $228.73 = 4.38%.
The average inflation rate over 6 years is
1/6
 $287.84 
f    1  0.093  9.30%
 $168.82 
Inflation Terminology – II
 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.
 Constant Dollars (An’ ): Estimates of future
cash flows for year n in constant purchasing
power, independent of the passage of time
(or base period).
Conversion from Constant to
Actual Dollars
_ _
An  A' n (1  f )  A' n ( F / P, f , n)
n
n3 $1,260
$1,000 _
f  8%
0 3
3
Actual
Constant
Base period 3 Dollars
Dollars $1,000 (1 + 0.08)
= $1,260
Conversion from Constant to
Actual Dollars
Average inflation rate = 5%
Period Net Cash Flow in Conversion Cash Flow in
Constant $ Factor Actual $
0 -$250,000 (1+0.05)0 -$250,000
1 100,000 (1+0.05)1 105,000
2 110,000 (1+0.05)2 121,275
3 120,000 (1+0.05)3 138,915
4 130,000 (1+0.05)4 158,016
5 120,000 (1+0.05)5 153,154

Conversion from Actual to
Constant Dollars
_ _
n
A' n  An (1  f )  An ( P / F, f , n)
n3 $1,260
$1,000 _
f  8%
3
0 3
Actual
Constant -3
$1,260 (1 + 0.08) Dollars
Dollars
Base period = $1,000
Conversion from Actual to
Constant Dollars
End of Cash Flow Conversion Cash Flow in Loss in
period in Actual $ at f = 5% Constant $ Purchasing
Power
0 $20,000 (1+0.05)0 $20,000 0%
1 20,000 (1+0.05)-1 19,048 4.76
2 20,000 (1+0.05)-2 18,141 9.30
3 20,000 (1+0.05)-3 17,277 13.62
4 20,000 (1+0.05)-4 16,454 17.73

U.S. Gasoline Prices, 1950 to 2006, in Actual
and Constant (Year 2005) cents per gallon
Source: http://oregonstate.edu/Dept/pol_sci/fac/sahr/GASoline.xls

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Meaning and Measure of

 How do we measure inflation?

 How do we incorporate the effect of

 Time Value of Money

1990 1990 2008

$2.00 / unit 75%

2005 2006 2007 2008 2005 2006 2007 2008

You could purchase You can now purchase

$100 ( 1 + 0.04) ( 1 + 0.08) = $112.32

Step 2: Find the average inflation rate by solving the

Average inflation rate based on the CPI

2007 ? ($228.73 - $209.44) / $209.44 = 9.21 %.

1 100,000 (1+0.05)1 105,000

2 110,000 (1+0.05)2 121,275

3 120,000 (1+0.05)3 138,915

4 130,000 (1+0.05)4 158,016

5 120,000 (1+0.05)5 153,154

1 20,000 (1+0.05)-1 19,048 4.76

2 20,000 (1+0.05)-2 18,141 9.30

3 20,000 (1+0.05)-3 17,277 13.62

4 20,000 (1+0.05)-4 16,454 17.73

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