Doctoral Program and Advanced Degree in Sustainable Energy

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Doctoral Program and Advanced Degree in Sustainable Energy Systems Doctoral Program in Mechanical Engineering Doctoral Program in Environmental Engineering Ecological Economics Lecture 07 Tiago Domingos Assistant Professor Environment and Energy Section Department of Mechanical Engineering

Temporal Comparison - Real vs Nominal • Inflation – changes in consumer prices • Affects: – Exports, – Erosion of consumer power – Distorts the intertemporal comparisons of variables in monetary units, e. g. , evaluating the profitability of an investment. • What part of the change in national accounts aggregates at current prices comes from a change in the quantities (changes in volume) produced and what part comes from a change in prices (inflation)?

Temporal Comparison - Real vs Nominal Item Quantity Price 2007 Nominal GDP in: - 2008, € 575 100 € 1. 00 Butter 20 € 5. 00 Bread 160 € 0. 50 Butter - 2007, € 200 Bread 22 € 22. 50 2008 Growth rate: 187, 5 % • What is the nominal GDP in each year and the nominal GDP growth rate? • What does the above value represent? • How to obtain real (volume) growth changes?

Price Level and CPI • Consumer Price Index (CPI) – It is based on a fixed (changes every 5 years) basket of goods that are normally an important part of households’ consumption. • 1 – Fix the Basket – which prices are most important to the typical consumer? Put weights by surveying consumers and finding the basket of goods and services that the typical consumer buys. • 2 – Find the prices for each good and service in the basket. • 3 – Compute the basket’s cost (price times quantity) • 4 – Choose a base year and compute the CPI Formula • 5 – Compute inflation as the rate of change in CPI

Price Level and CPI Item Quantity Price 2007 Cost of Basket CPI € 10 € 25 Bread 100 20 250 € 1. 00 Butter 100 € 5. 00 2008 Bread 160 € 0. 50 Butter 22 € 22. 50 • Basket of goods: 5 Breads, 1 Butter • What is the inflation rate? • Inflation rate = rate of change of price level, • 150% = (250 -100)/100

Price Level and CPI Item Nominal GDP CPI Real GDP 2007 € 200 100 € 2008 € 575 250 € 230 • Using the CPI to deflate Vyear x to Vbase year: • Vbase year = (CPIbase year ÷ CPIyear x ) Vyear x. • What is the real GDP and its real growth rate? • 15 % • What does the above value represent, compared to nominal growth 187, 5%?

CPI in Portugal • First national CPI (PT) in 1977, after “inquérito às despesas das famílias” 1973/1974. • Increase in number of items, establishments and reference population • Now: Fixed base year using average prices of 2008 (Changed in 1976, 1983, 1991, 1997) • CPI is in fact composed of several indexes for different classes of consumption (COICOP - Classification Of Individual COnsumption by Purpose) • More than 700 items (goods and services) in more than 10 000 establishments yielding more than 70 000 prices on a monthly basis for a given reference population (total population). • These basket is changed every 5 years.

CPI in Portugal: Basket COICOP (1) Divisions, Groups and Classes Food and non alcoholic beverages Food Bread and cereals Meat Fish Milk, cheese and eggs Oils and fats Fruit Vegetables Sugar, jam, honey, chocolate and confectionery Food products n. e. c. Non-alcoholic beverages Coffee, tea and cocoa Mineral waters, soft drinks, fruit and vegetable juices Alcoholic beverages, tobacco Alcoholic beverages Spirits Wine Beer Tobacco Jan 99, 9 101, 1 101, 8 98, 9 99, 0 98, 2 95, 8 100, 7 101, 1 99, 5 100, 1 101, 5 99, 6 Year: 2009 Feb Mar 99, 4 98, 8 101, 3 101, 1 100, 2 99, 7 98, 4 95, 5 97, 3 96, 4 94, 4 96, 1 97, 9 102, 8 104, 9 101, 1 100, 9 99, 9 100, 4 99, 8 100, 0 101, 0 100, 8 99, 3 99, 7 Apr 98, 3 98, 2 101, 2 99, 4 93, 4 95, 3 93, 1 98, 7 105, 3 101, 0 100, 7 101, 6 100, 4 101, 4 102, 4 99, 9 103, 0 101, 9 101, 0 101, 5 102, 5 101, 2 103, 0 101, 4 101, 0 103, 1 102, 4 99, 5 103, 7 100, 1 103, 3 103, 1 102, 4 100, 1 103, 5 100, 4 103, 2

Clothing and footwear Clothing materials Garments Other articles of clothing and clothing accessories Cleaning, repair and hire of clothing Shoes and other footwear including repair and hire of footwear Footwear Repair and hire of footwear Housing, water, electricity, gas and other fuels Actual rentals for housing Actual rentals paid by tenants including other actual rentals Maintenance and repair of the dwelling Materials for the maintenance and repair of the dwelling Services for the maintenance and repair of the dwelling Water supply and miscellaneous services relating to the dwelling Water supply Refuse collection (2) Sewerage collection (2) Other services relating to the dwelling n. e. c. Electricity, gas and other fuels Electricity Gas Liquid Fuels (2) Solid fuels 88, 5 87, 7 101, 0 87, 1 88, 2 100, 8 90, 9 90, 6 102, 2 85, 8 85, 1 100, 3 84, 3 87, 5 101, 1 87, 8 87, 5 102, 5 103, 0 103, 2 100, 2 103, 4 95, 7 101, 2 102, 6 103, 7 103, 8 102, 0 104, 0 97, 5 101, 4 103, 4 102, 7 101, 8 101, 4 101, 9 101, 1 103, 2 101, 9 101, 4 102, 5 105, 5 101, 0 104, 2 95, 1 97, 2 100, 2 101, 9 101, 7 101, 4 102, 0 101, 1 104, 0 102, 9 101, 8 104, 4 105, 5 100, 8 104, 2 94, 5 96, 4 100, 5 102, 0 102, 2 101, 5 102, 2 101, 1 104, 4 103, 4 102, 6 104, 7 105, 5 100, 5 104, 2 94, 5 90, 9 98, 4 101, 9 102, 4 101, 8 102, 6 101, 3 104, 6 103, 9 104, 7 105, 5 100, 1 104, 2 92, 6 95, 0 98, 6

Furnishings, household equipment and routine maintenance of the house Furniture and furnishings, carpets and other floor covering Furniture and furnishings Carpets and other floor coverings Repair of furniture, furnishings and floor coverings Household textiles Household appliances Major electric household appliances Small electric household appliances Repair of household appliances Glassware, tableware and household utensils Tools and equipment for house and garden Major tools and equipment for house and garden Small tools and miscellaneous Goods and services for routine household maintenance Non-durable household goods Domestic services and household services 101, 9 99, 8 99, 4 101, 9 100, 3 100, 5 100, 4 100, 6 101, 5 100, 8 101, 6 100, 3 101, 7 103, 5 100, 4 105, 6 101, 7 99, 4 98, 8 102, 3 99, 3 100, 4 100, 2 100, 7 102, 4 100, 8 101, 9 100, 2 102, 3 103, 4 100, 0 105, 6 101, 8 99, 6 98, 1 102, 4 98, 8 100, 5 100, 3 101, 0 102, 6 100, 9 101, 8 100, 4 102, 1 103, 5 100, 4 105, 6 101, 8 99, 6 99, 5 102, 8 99, 4 100, 1 100, 9 102, 8 101, 1 101, 9 99, 9 102, 5 103, 5 100, 3 105, 7

Health Medical products, appliances and equipment Pharmaceutical products Other products and medical appliances Therapeutic appliances and equipment Out-patient services Medical services Dental services Paramedical services Hospital services 99, 6 98, 2 97, 2 101, 3 101, 1 100, 7 100, 9 100, 7 100, 0 100, 7 99, 3 98, 3 97, 2 101, 4 101, 3 100, 9 101, 3 100, 7 100, 2 95, 7 99, 3 98, 2 97, 0 101, 4 101, 6 100, 9 101, 4 100, 7 100, 2 95, 7 99, 4 98, 4 97, 1 101, 9 101, 1 101, 5 100, 9 100, 3 95, 9 Transport Purchase of vehicles Motor cars Motor cycles Bicycles Operation of personal transport equipment Spare parts and accessories Fuels and lubricants Maintenance and repair of personal transport equipment Services in respect of personal transport equipment Transport services Passenger transport by railway Passenger transport by road Passenger transport by air Passenger transport by sea and inland waterway Combined passenger transport Other purchased transport services 93, 6 101, 5 100, 6 100, 8 86, 2 98, 1 78, 6 100, 8 101, 8 95, 9 101, 0 102, 8 79, 7 103, 2 100, 1 99, 1 94, 7 101, 4 101, 2 100, 4 88, 0 97, 5 80, 9 101, 2 101, 9 97, 7 101, 7 103, 3 85, 8 103, 5 100, 1 99, 1 94, 4 101, 3 101, 8 99, 6 87, 6 96, 7 80, 3 102, 1 102, 0 96, 8 101, 7 103, 4 82, 0 103, 5 100, 1 99, 1 95, 7 101, 1 102, 9 98, 9 89, 8 96, 2 83, 1 102, 7 102, 1 98, 3 101, 7 103, 4 88, 0 105, 9 100, 1 99, 3

Communication 98, 3 98, 2 99, 3 Postal services 102, 2 103, 9 103, 9 Telephone and telefax equipment 89, 0 88, 6 88, 5 89, 0 Telephone, telegraph and telefax services 98, 4 98, 3 99, 5 Education Pre-school and primary education Primary and secondary school Higher education Other types of education Hotels and restaurants Catering services Restaurants, cafes, bars and like Canteens Accommodation services 102, 5 102, 8 100, 9 103, 0 102, 6 102, 7 102, 8 101, 2 103, 0 103, 1 102, 7 102, 8 101, 2 103, 0 103, 2 102, 7 102, 8 101, 2 103, 0 103, 4 101, 3 101, 7 101, 2 106, 1 89, 5 101, 5 102, 1 101, 5 106, 3 87, 0 101, 9 102, 4 101, 9 106, 5 89, 6 102, 4 102, 5 102, 0 106, 7 98, 9

Recreation and culture Audio-visual, photographic and data processing equipment Equipment for the reception, recording and reproduction of sound and pictures Photographic and cinematographic equipment and optical instruments Data processing equipment Recording media for pictures and sound Repair of audio-visual, photographic and data processing and accessories Other major durables for recreation and culture Major durables for outdoor recreation (2) Major durables for indoor recreation including musical instruments Other recreational items and equipment, garden and pets Games, toys and hobbies, equipment for sport camping and open-air recreation Other recreational items for hobbies and recreation Gardening Pets and related products Recreational and cultural services Recreation and sporting services Cultural services Games of chance Newspapers, books and stationery Books Newspapers and periodicals Miscellaneous printed materials Package holidays 99, 1 96, 0 90, 9 92, 5 99, 0 102, 7 98, 0 100, 0 97, 6 102, 1 97, 0 98, 8 108, 7 102, 1 99, 8 98, 4 100, 0 102, 1 101, 6 103, 5 100, 6 91, 8 99, 1 94, 2 94, 6 91, 1 90, 2 96, 6 103, 2 98, 4 100, 2 98, 4 103, 3 95, 8 98, 9 115, 2 102, 6 100, 2 100, 1 100, 6 100, 0 102, 0 101, 3 103, 6 100, 7 90, 8 98, 4 92, 2 92, 5 90, 0 87, 9 94, 8 103, 7 98, 9 100, 2 99, 3 100, 0 95, 6 98, 9 98, 1 102, 7 100, 3 100, 4 100, 7 100, 0 101, 5 100, 0 103, 6 101, 5 91, 2 98, 6 92, 0 92, 1 88, 8 87, 4 95, 7 104, 6 98, 9 100, 2 99, 4 99, 7 94, 7 99, 3 94, 4 103, 8 101, 3 100, 3 102, 6 100, 0 101, 7 100, 4 103, 7 101, 6 90, 0

CPI in Portugal: Basket Miscellaneous goods and services Personal care Hairdressing salons and personal grooming establishment Articles for personal care Products for personal care Personal effects n. e. c. Jewellery, clocks and watches Other personal effects Social protection services Insurance connected with the dwelling Insurance connected with health (2) Insurance connected with transport Other insurance (2) Financial services n. e. c. 101, 4 101, 2 101, 0 101, 2 102, 2 104, 1 99, 5 103, 0 100, 5 102, 2 100, 9 100, 0 100, 6 100, 7 101, 5 101, 4 101, 6 100, 8 103, 1 97, 8 103, 1 100, 3 102, 2 101, 7 99, 6 100, 7 101, 6 101, 8 101, 7 101, 3 101, 9 101, 4 103, 2 98, 8 103, 1 100, 3 102, 2 101, 7 99, 6 100, 8 101, 9 102, 2 102, 0 100, 8 102, 3 102, 1 103, 7 99, 7 103, 1 100, 3 102, 2 101, 7 99, 5 100, 6 101, 0 • Example: • Washing machine; white; frontal door; 5 kg of clothes; 2200 W; 12 – 14 programs • Pants; Wool (45%) and polyester (55%), two lateral pockets; one back pocket, no fold; good finishings, 46/48.

Inflation rate in Portugal [%] 35 30 25 20 15 10 5 0 1961 1966 1971 -5 Source: AMECO database 1976 1981 1986 1991 1996 2001 2006

Real vs. Nominal (Portugal) [Mrd euros] 2000000 1800000 Gross domestic product at 2000 market prices Gross domestic product at current market prices 1600000 1400000 1200000 1000000 800000 600000 400000 200000 0 1965 1970 Source: AMECO database 1975 1980 1985 1990 1995 2000 2005 2010

Problems with the CPI • Objective: Measure changes in the cost of living • Substitution bias: • prices change differently consumers buy more of cheaper goods, yet the basket is fixed. • Overstates the increase in prices • Technological progress • New goods more variety each € is more valuable since it buys more goods. E. g. , introduction of VCRs • CPI even with the revised basket never shows the decrease in life cost due to new products. • Quality Change: • Quality increases value of one € decreases even if the price of the good stays the same • Prices are adjusted but quality is hard to measure • No environmental goods, …

Present Value of Money • Present Value – Conversion of money flows to their present value • • • NPV: Net Present Value i: interest rate VFt(t): value at instant t If VF is in current prices then i is the nominal interest rate If VF is in constant prices then i is the real interest rate

Nominal vs. real interest rates The Fisher relation For low rates, this is approximately equal to

Present Value of Utility • Welfare – Discrete time – Continuous time

Discount Rate Justification and Components • The same monetary flow at different instants does not have the same value (time preference) – CONSUMPTION: Uncertainty • Being alive in the future (individual vs. society) • Preferences in the future • Value of the benefit or the cost – CONSUMPTION: Impatience – PRODUCTION: Capital productivity (opportunity cost of capital) • Under certain conditions, the discount rate is equal to the real market interest rate consumption discount rate pure time preference rate per capita consumption growth rate utility discount rate variation in survival probability elasticity of the marginal utility of consumption Turner et al. (1994), pp. 102 -106.

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