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Equivalence Involving Inflation

Measures of Inflation and Deflation
Inflation and deflation are terms that describe changes in price levels in an economy. Without addressing the causes of the changes in price levels, the focus here will be on the methods needed to determine the rate of change of price levels and how these changes should be reflected inengineering economy studies.
The prices of goods and services are driven upward or downward because of numerous factors at work within the economy. The cumulative effect of these factors determines the amount of price change.
A price index is the ratio of the historical price of some commodity or service at some point in time to the price at some earlier point. When incorporating changes of pricelevels in engineering economy studies, the index selected should measure those changes that are pertinent to the individual organization undertaking study.
The Inflation Rate
It is customary to utilize an annual percentage rate representing the annual increase or decrease in price over a one-year time span. Since the rate each year is based on the previous year's prices, this rate has acompounding effect. Because of the compounding nature of inflation of deflation rates, the interest formulas derives un Chapter 3 for the earning power of money may be used when computing the effects of changes in prices (i.e., changes in the purchasing power of money).
Computing the Inflation Rate
The historical annual rate of price increase can be computed from any of the several available indexes.Most economic studies require the use of estimates that depend on expectations of future inflation rates. The determination of these future rates should be based on the trends of historical rates, predicting economic conditions, judgment, and the other elements of economic forecasting.
Many studies use an average annual inflation rate when the projected life of the investment is long. Thisapproach requires the estimated of a single average rate that represents a composite of the individual yearly rates. The decision whether to use individual annual inflation rates or an average composite rate should be based in judgment.
The Purchasing Power of Money
As prices increase or decrease, the amount of goods and services that can be purchased for a fixed amount of money decreases or increasesaccordingly. Under inflationary conditions the purchasing power of money is decreasing.
Considering the Effects of Inflation
Two basic approaches are presented that allow for the simultaneous consideration of changes in money's earning power and purchasing power. These approaches are consistent and, if applied properly, will lead to identical conclusions. The first approach assumes that cashflows are measured in terms of actual dollars; the second uses the concept of constant dollars.
Definitions of i, i', and f
To develop the relationships between actual-dollar analysis and constant-dollar analysis, precise definitions are needed for the various interest rates to be used in the calculations.
The market rate represents the opportunity to earn as reflected by the actual rates ofinterest available in finance and business. This rate is a function of the investment activities of investors who are operating within this market. Since the preceding and subsequent chapters generally assume that cash flows are in terms of actual dollars, the rate used in the calculations is the market interest rate.
The rate has been denoted by I, and this designated is used consistently torepresent the interest rates available in the marketplace. When a firm states its minimum attractive rate of return it is usually a market rate of interest.
Other names: combined interest rate, current dollar interest rate, actual interest rate, inflated interest rate.
The inflation-free interest rate represents the earning power of money with the effects of inflation removed. This interest rate...