What is Inflation
• Up until now, we have largely been assuming
that prices remain relatively constant
throughout the course of the analysis
3.080 Econ & Enviro Issues In Materials Selection
Randolph Kirchain
Massachusetts Institute of Technology
Department of Materials Science & Engineering
Engineering Economic Analysis: Slide 107
Page 1
Price of Gasoline in US
350
Price (cents / gallon)
300
250
Nominal Dollars
Real Dollars
200
150
100
50
0
1940
1960
1980
2000
2020
3.080 Econ & Enviro Issues In Materials Selection
Randolph Kirchain
Massachusetts Institute of Technology
Department of Materials Science & Engineering
Engineering Economic Analysis: Slide 108
Page 2
CPI & PPI
• General price inflation
– Increase in the average price paid for goods and services Æ
reduced purchasing power of money
• Consumer Price Index (CPI)
– Average change in the price of a basket of consumer goods
• Food, shelter, medicine, transport, apparel, etc.
• Formally tracked by federal government since 1967
• Producer Price Index
– Average change in price of basket of industrial goods
– Tracked by Standard Industrial Classification (SIC) code
• Both indices are measured against a base period (Originally,
1967, now a weighting of 1982-1984) = 100
3.080 Econ & Enviro Issues In Materials Selection
Randolph Kirchain
Massachusetts Institute of Technology
Department of Materials Science & Engineering
Engineering Economic Analysis: Slide 109
Page 3
200
180
160
140
120
100
80
60
40
20
0
20%
CPI
Inflation Rate
15%
10%
5%
0%
-5%
-10%
-15%
19
13
19
20
19
27
19
34
19
41
19
48
19
55
19
62
19
69
19
76
19
83
19
90
19
97
20
04
CPI
Historic Statistics on Inflation
3.080 Econ & Enviro Issues In Materials Selection
Randolph Kirchain
Massachusetts Institute of Technology
Department of Materials Science & Engineering
Engineering Economic Analysis: Slide 110
Page 4
Terminology
• Actual dollars
– Number of dollars associated with a cash flow when it occurs
– Synonyms: Nominal, current, inflated dollars
• Real dollars
– Dollars adjusted to a common purchasing power
– Synonym: Constant
• Market interest rate
– Money paid for the use of capital that includes a market
adjustment for anticipated inflation
• Inflation free (Real) Interest Rate
– Money paid for the use of capital that does NOT include an
adjustment for anticipated inflation
3.080 Econ & Enviro Issues In Materials Selection
Randolph Kirchain
Massachusetts Institute of Technology
Department of Materials Science & Engineering
Engineering Economic Analysis: Slide 111
Page 5
Mapping Actual and Real Dollars
• Actual dollars in year k can be converted to real
dollars of constant purchasing power of any base
period b
( A$)k
= ( A$)k (P / F , f %, k − b )
(R $)k =
k −b
(1 + f )
3.080 Econ & Enviro Issues In Materials Selection
Randolph Kirchain
Massachusetts Institute of Technology
Department of Materials Science & Engineering
Engineering Economic Analysis: Slide 112
Page 6
Choosing the correct interest rate for
your analysis
Also known as:
Now What Do I Do?
3.080 Econ & Enviro Issues In Materials Selection
Randolph Kirchain
Massachusetts Institute of Technology
Department of Materials Science & Engineering
Engineering Economic Analysis: Slide 113
Page 7
Correct Interest Rate: 3 Possible Cases
1) Cash flows known in Constant Dollars
2) Cash flows known in Actual Dollars
3) Cash flows known in mixed basis
# 3 is easy Æ Either convert all to Constant
Dollars or convert all to Actual Dollars and
see appropriate method as follows
3.080 Econ & Enviro Issues In Materials Selection
Randolph Kirchain
Massachusetts Institute of Technology
Department of Materials Science & Engineering
Engineering Economic Analysis: Slide 114
Page 8
Choosing the Correct Interest Rate
• Cash flows in constant dollars Æ
Use the inflation-free rate
3.080 Econ & Enviro Issues In Materials Selection
Randolph Kirchain
Massachusetts Institute of Technology
Department of Materials Science & Engineering
Engineering Economic Analysis: Slide 115
Page 9
Choosing the Correct Interest Rate
• Cash flows in Actual dollars
– Deflation Method
• Convert cash flows into constant dollars and use
inflation-free rate
– Adjusted Discount Method
• Compute Market based rate from inflation free and
general inflation
• Compute Equivalent Worth using Market Based
Rate
3.080 Econ & Enviro Issues In Materials Selection
Randolph Kirchain
Massachusetts Institute of Technology
Department of Materials Science & Engineering
Engineering Economic Analysis: Slide 116
Page 10
Finding the Market Based Rate
• Consider the two
step Deflated
Method
– Adjust cash
flows based on
inflation = 1 /
(1+f)n
– Discount cash
flows using
inflation free =
1 / (1+i’)n
3.080 Econ & Enviro Issues In Materials Selection
Randolph Kirchain
Massachusetts Institute of Technology
Department of Materials Science & Engineering
Engineering Economic Analysis: Slide 117
Page 11