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L 11: Measure of Inflation ECON 320 Engineering Economics Mahmut Ali GOKCE Industrial Systems L 11: Measure of Inflation ECON 320 Engineering Economics Mahmut Ali GOKCE Industrial Systems Engineering Computer Sciences www. izmirekonomi. edu. tr

Chapter 4 Equivalence Calculations Under Inflation n Measure of Inflation Actual versus Constant Dollars Chapter 4 Equivalence Calculations Under Inflation n Measure of Inflation Actual versus Constant Dollars Equivalence Calculations under Inflation www. izmirekonomi. edu. tr

All-Time Top 10 Movies www. izmirekonomi. edu. tr All-Time Top 10 Movies www. izmirekonomi. edu. tr

Inflation and Economic Analysis q What is inflation? q How do we measure inflation? Inflation and Economic Analysis q What is inflation? q How do we measure inflation? q How do we incorporate the effect of inflation in equivalence calculation? www. izmirekonomi. edu. tr

What is Inflation? q Value of Money Earning Power Purchasing power q Earning Power What is Inflation? q Value of Money Earning Power Purchasing power q Earning Power Investment Opportunity q Purchasing Power Decrease in purchasing power (inflation) Increase in Purchasing Power (deflation) www. izmirekonomi. edu. tr

Purchasing Power $100 1990 You could buy 50 Big Macs in year 1990. $2. Purchasing Power $100 1990 You could buy 50 Big Macs in year 1990. $2. 00 / unit 2003 You can only buy 40 Big Macs in year 2003. 25% Price change due to inflation $2. 50 / unit The $100 in year 2003 has only $80 worth purchasing power of 1990 www. izmirekonomi. edu. tr

$100 -2 -1 $100 0 1 -2 0 1 You can now purchase 80 $100 -2 -1 $100 0 1 -2 0 1 You can now purchase 80 gallons of unleaded gas. You could purchase 63. 69 gallons of unleaded gas a year ago. $1. 57 / gallon -1 20. 38% $1. 25 / gallon Price change due to deflation www. izmirekonomi. edu. tr

Inflation Terminology - I n Producer Price Index: a statistical measure of industrial price Inflation Terminology - I n Producer Price Index: a statistical measure of industrial price change, compiled monthly by the BLS, U. S. Department of Labor n 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 n Average Inflation Rate (f): a single rate that accounts for the effect of varying yearly inflation rates over a period of several years. n General Inflation Rate (f ): the average inflation rate calculated based on the CPI for all items in the market basket. www. izmirekonomi. edu. tr

Measuring Inflation Consumer Price Index (CPI): the CPI compares the cost of a sample Measuring Inflation 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. Market basket Base Period (1982 -84) $100 2002 $179. 9 CPI for 2002 = 179. 9 www. izmirekonomi. edu. tr

Selected Price Indexes www. izmirekonomi. edu. tr Selected Price Indexes www. izmirekonomi. edu. tr

Average Inflation Rate (f) Fact: Base Price = $100 (year 0) Inflation rate (year 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 following equivalence equation. 2 $100 ( 1+ f) = $112. 32 f = 5. 98% 0 $112. 32 1 2 $100 www. izmirekonomi. edu. tr

Example 4. 1 Average Inflation Rate Item 2003 Price 2000 Price Consumer price index Example 4. 1 Average Inflation Rate Item 2003 Price 2000 Price Consumer price index (CPI) $184. 20 $171. 20 2. 47 0. 33 6. 44 Homeowners Insurance 603. 00 500. 00 7. 56 Private college tuition and fees 18, 273 15, 518 5. 60 1. 65 1. 56 1. 89 12. 00 10. 50 4. 55 Car (Toyota Camry) 22, 000 21, 000 1. 56 Natural gas (MBTU) 5. 67 3. 17 21. 38 148. 66 132. 44 3. 92 47. 97 36. 97 9. 07 Postage Gasoline Haircut Baseball tickets Cable TV Average Inflation Rate (%) www. izmirekonomi. edu. tr

General Inflation Rate (f) Average inflation rate based on the CPI www. izmirekonomi. edu. General Inflation Rate (f) Average inflation rate based on the CPI www. izmirekonomi. edu. tr

Example 4. 2: Yearly and Average Inflation Rates Year Cost 0 $504, 000 1 Example 4. 2: Yearly and Average Inflation Rates Year Cost 0 $504, 000 1 538, 000 2 577, 000 3 629, 500 What are the annual inflation rates and the average inflation rate over 3 years? Solution Inflation rate during year 1 (f 1): ($538, 400 - $504, 000) / $504, 000 = 6. 83%. Inflation rate during year 2 (f 2): ($577, 000 - $538, 400) / $538, 400 = 7. 17 %. Inflation rate during year 3 (f 3): ($629, 500 - $577, 000) / $577, 000 = 9. 10%. The average inflation rate over 3 years is www. izmirekonomi. edu. tr