Lecture No. 35
Chapter 11
Contemporary Engineering Economics
Copyright © 2010
Contemporary Engineering Economics, 5th edition, © 2010
Chapter Opening Story
How Much Will It Cost to
Send Your Child to College
in Year 2015?
A year in college cost
$17,800 in 2005.
Due to inflation, the
college expense has been
increasing at a rate of 6.5%
annually.
Then, in 2015 a year in
college would cost about
$33,413.
 College Cost Calculator
Contemporary Engineering Economics, 5th edition, © 2010
Inflation and Economic Analysis

What is inflation?
 How do we measure inflation?
 How do we incorporate the effect of inflation in
equivalence calculation?
Contemporary Engineering Economics, 5th edition, © 2010
What is Inflation?
 Time Value of Money
Definition: Inflation is
Earning Power
the rate at which the
Purchasing Power
general level of prices
and goods and services is  Earning Power
rising, and subsequently,
Investment Opportunity
purchasing power is
falling.
 Purchasing Power
Decrease in purchasing power (inflation)
Increase in purchasing power (deflation)
Contemporary Engineering Economics, 5th edition, © 2010
Inflation - Decrease in Purchasing Power
$100
$100
1990
1990
You could buy 50 Big Macs
in year 1990 with $100
$2.00 / unit
2010
You can only buy 28.5 Big
Macs in year 2010.
75%
Price change
due to
inflation
$3.50 / unit
The $100 in year 2010 has only $57
worth purchasing power of 1990
Contemporary Engineering Economics, 5th edition, © 2010
Deflation - Increase in Purchasing Power
$100
2004
2005
$100
2006
2010
You could purchase
63.69 gallons of purified
drink water a year ago.
$1.57 / gallon
2004
2005
2006
2010
You can now purchase
80 gallons of purified
drink water.
20.38%
$1.25 / gallon
Price change due to
deflation
Contemporary Engineering Economics, 5th edition, © 2010
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 average 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.
Contemporary Engineering Economics, 5th edition, © 2010
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.
 CPI (Old measure) – Base Period = 1967
 1967
100
 2010
649.10 (January)
 CPI (New measure) – Base Period
(1982-84)
 1982-84
 2010
100
216.68 (January)
Contemporary Engineering Economics, 5th edition, © 2010
Selected Price Indexes (Index for Base Year = 100,
Calendar Month = April)
Contemporary Engineering Economics, 5th edition, © 2010
Average Inflation Rate (f )
Fact:
Base Price = $100 (year 0)
 Step 1: Find the actual inflated price at the end
of year 2.
Inflation rate (year 1) = 4%
Inflation rate (year 2) = 8%
Find: Average inflation rate over
2 years?
$100 ( 1 + 0.04) ( 1 + 0.08) = $112.32
 Step 2: Find the average inflation rate by solving
the following equivalence equation.
$100 ( 1+ f)2 = $112.32
f = 5.98%
0
$112.32
1
2
$100
Contemporary Engineering Economics, 5th edition, © 2010
Example 11.1 Average Inflation Rate
Sample Calculation for
Average Inflation rate for
Gasoline:
 Average Inflation Rate
Given: P = 127.3, F =
175.3, N = 2009-2000 = 9.
Find: f
Contemporary Engineering Economics, 5th edition, © 2010
General Inflation Rate (f)
Formula:
Calculation:
 Given:
_
CPIn  CPI0 (1  f )n ,
1/ n
 CPI 
f   n  1
 CPI0 
_
 CPI for 2009 = 213.2,
_
where
f  The genreal inflation rate,
where
CPI  The consumer price index at the end period n,
Theconsumer
consumer price
index
for theatbase
CPICPI=0 The
price
index
theperiod.
end
n
general inflation rate
f = The
n
of period n,
CPI0 = The consumer price index for the
base period.
 CPI for 2000 = 172.2
 Find: f
 213.2 
f 
 172.2 
 2.40%
Contemporary Engineering Economics, 5th edition, © 2010
1/9
1
Example 11.2 Yearly and Average Inflation Rates
 Year
cost data:
Year
Cost
0
$504,000
1
538,000
2
577,000
3
629,500
 Solution:
 Find: Yearly and Average
inflation rates
Contemporary Engineering Economics, 5th edition, © 2010
Inflation Terminology – II
 Actual Dollars (An ): Estimates of future cash
flows for year n that take into account any
anticipated future 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).
Contemporary Engineering Economics, 5th edition, © 2010
Finding Actual Dollars
 Conversion from Constant to Actual
Dollars
 General inflation rate = 5%
Period
Net Cash Flow in
Constant $
Conversion
Factor
Cash Flow in
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
Contemporary Engineering Economics, 5th edition, © 2010
Finding Constant Dollars
 Conversion from Actual to Constant
dollars
 Example 11.4 - General inflation
rate of 5%
End of
period
Cash Flow in
Actual $
Conversion
at f = 5%
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
Contemporary Engineering Economics, 5th edition, © 2010
Cash Flow in
Constant $
Loss in
Purchasing
Power