Equivalence Calculation

Under Inflation
UMAK-ENGG ECONOMY
Measure of Inflation
Inflation and Economic Analysis

 What is inflation?
 What are causes inflation?
 What are effects of inflation?
 How do we measure inflation?
 How do we incorporate the effect of
inflation in equivalence calculation?
 What is Inflation?
A loss in the purchasing power of money over time. Inflation
means that the cost of an item tends to increase over time, or
the same dollar amount buys less of an item over time.

Value of Money
Earning Power How much you currently make at your place of
employment plays a major part in your earning power.
Purchasing power The value of a currency expressed in terms
of the amount of goods or services that one unit of money can buy.

 Purchasing Power
Decrease in purchasing power (inflation)
Increase in Purchasing Power (deflation)
 Earning Power
 True Earning Power = (Monthly Income - Monthly
Taxes and Necessity Expenses) / Time

 For example: John makes $5,000 a month. His

taxes and living expenses total $4,000 a month. He
usually wake up at 6:30 AM to get ready for work,
and return home around 6:30 PM each day; totaling
about 12 hours per day, 60 hours per week, or
approximately 260 hours per month. Using the
equation above, John’s true earning power is only
$3.85 per hour!
 Purchasing Power

$100 $100

1990 1990 2003

You could buy 50 Big Macs You can only buy 40 Big
in year 1990. Macs in year 2003.

25%
$2.00 / pc. $2.50 / pc.
Price change
due to
inflation
The $100 in year 2003 has only $80
worth purchasing power of 1990
 $100 $100

-2 -1 0 1 -2 -1 0 1

You could purchase 63.69 You can now purchase 80

gallons of unleaded gas gallons of unleaded gas.
a year ago.

20.38%
$1.57 / gallon $1.25 / gallon
Price change due to
deflation
 Inflation Terminology - I
 Producer Price Index (PPI): a statistical measure of
wholesale industrial price change, compiled monthly by the NSO, to
evaluate wholesale price levels in the economy. Its components are
broken down by industry sector, product.

 Consumer Price Index (CPI): 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 city consumers

 Average Inflation Rate ( f ): a single 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.
 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) 2002
$100 $179.9
CPI for 2002 = 179.9
 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 $112.32

following equivalence equation.

0 1
2
$100 ( 1+ f) = $112.32 2
f = 5.98%
$100
Example 4.1 Average Inflation Rate
Item 2003 2000 Average Inflation
(CPI) Base Period: 1982 - 84 = 100 Price Price Rate (%)
Consumer price index (CPI) $184.20 $171.20 2.47
Postage 0.37 0.33 3.9
Homeowners Insurance 603.00 500.00 6.44
Private college tuition and fees 18,273 15,518 5.60
Gasoline 1.65 1.56 1.89
Haircut 12.00 10.50 4.55
Car (Toyota Camry) 22,000 21,000 1.56
Natural gas (MBTU) 5.67 3.17 21.38
Baseball tickets 148.66 132.44 3.92
Cable TV 47.97 36.97 9.07
General Inflation Rate ( f )
Average inflation rate based on the CPI
_
CPI n  CPI 0 (1  f ) n ,
_ 1/ n
CPI n
f  1
CPI 0
_
where f  The genreal inflation rate,
CPI n  The consumer price index at the end period n,
CPI 0  The consumer price index for the base period.

13
Example 4.2: Yearly and Average Inflation Rates

Year Cost What are the annual inflation rates

0 $504,000 and the average inflation rate over 3 years?
1 538,000
2 577,000
3 629,500 Solution
Inflation rate during year 1 (f1):
($538,400 - $504,000) / $504,000 = 6.83%.
Inflation rate during year 2 (f2):
($577,000 - $538,400) / $538,400 = 7.17 %.
Inflation rate during year 3 (f3):
($629,500 - $577,000) / $577,000 = 9.10%.
The average inflation rate over 3 years is
$629,500 1/ 3
f ( )  1  0.0769  7.69%
$504,000
Inflation Terminology – II
The effect of inflation into economic analysis

 Actual Dollars (An ):

Estimates of future cash flows for year n that take into
account any anticipated changes in amount caused by
inflationary or deflationary effects. Usually, these
amounts are determined by applying an inflation rate to
base-year dollar estimates.

 Constant (real) Dollars (A'n):

Represents constant purchasing power independent of
the passage of time. We will assume that the base year
is always time zero unless we specify otherwise.

15
 Conversion
from Constant to Actual Dollars
_ _
An  A' n (1  f )  A' n ( F / P, f , n)
n

n3 $1,260
$1,000
_
f  8%

3
3
Actual
Constant
3 Dollars
Dollars $1,000 (1 + 0.08)
= $1,260
 Example 4.3 Conversion from
Constant to Actual Dollars
Period Net Cash Flow in Conversion Cash Flow in
Constant $ Factor 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

 $120,000 $130,000
$110,000
$100,000 $120,000

0
1 2 3 4 5
Years

$130,000(1+0.05)4

$120,000(1+0.05)5
(a) Constant dollars
$100,000(1+0.05)

$120,000(1+0.05)3
$110,000(1+0.05)2
$250,000
$250,000(1+0.05)0

$138,915 $158,016
$121,275
$105,000 $153,154

0
1 2 3 4 5
Years
(b) Actual dollars
$250,000
 Conversion from
Actual to Constant Dollars
_ _
n
A' n  An (1  f )  An ( P / F, f , n)
n3 $1,260
$1,000
_
f  8%

3
3
Actual
Constant -3
$1,260 (1 + 0.08) Dollars
Dollars
= $1,000
 Example 4.4 Conversion from
Actual to Constant Dollars
End of Cash Flow in Conversion Cash Flow in Loss in
period Actual $ at f = 5% Constant $ Purchasing
Power
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

Equivalence Calculation Under Inflation
1. Types of Interest Rate
Market Interest rate (i)
Inflation-free interest rate (i')
2. Types of Cash Flow
In Constant Dollars
In Actual Dollars
3. Types of Analysis Method
Constant Dollar Analysis
Actual Dollar Analysis
Deflation Method
Adjusted-discount method
Inflation Terminology - III
 Inflation-free Interest Rate ( i' ): an estimate of the
true earning power of money when the inflation
effects have been removed (also known as real
interest rate).
 Market interest rate ( i ): commonly known as the
nominal interest rate, which takes into account the
combined effects of the earning value of capital
(earning power) and any anticipated inflation or
deflation (purchasing power). Most firms use a
market interest rate (also known as inflation-adjusted
required rate of return) in evaluating their investment
projects.

22
Inflation and Cash Flow Analysis
Constant Dollar analysis (inflation free interest rate i' )
• Estimate all future cash flows in constant dollars.
• Use i' as an interest rate to find equivalent worth.

Actual Dollar Analysis ( market interest rate i )

• Estimate all future cash flows in actual dollars.
• Use i as an interest rate to find equivalent worth.

23
Constant Dollar (A'n ) Analysis

 In the absence of inflation, all economic analyses up

to this point is, in fact, constant dollar analysis.

 Constant dollar analysis is common in the evaluation

of many long-term public projects, because
government do no pay income taxes.

 For private sector, income taxes are charged based

on taxable income in actual dollars, actual dollar
analysis is more common.
Actual Dollars (An ) Analysis

 Method 1: Deflation Method

Step 1: Bring all cash flows to have

common purchasing power.
Step 2: Consider the earning power.

 Method 2: Adjusted-discount Method

Combine Steps 1 and 2 into one step.

Example 4.6: Step 1: Convert actual dollars
to Constant dollars

n Cash Flows in Actual Multiplied by Cash Flows in

Dollars Deflation Constant Dollars
Factor

0 -$75,000 1 -$75,000

1 32,000 (1+0.05)-1 30,476

2 35,700 (1+0.05)-2 32,381

3 32,800 (1+0.05)-3 28,334

4 29,000 (1+0.05)-4 23,858

5 58,000 (1+0.05)-5 45,445

Step 2: Convert Constant dollars to
Equivalent Present Worth
n Cash Flows in Multiplied by Equivalent
Constant Dollars Discounting Present Worth
Factor
0 -$75,000 1 -$75,000
1 30,476 (1+0.10)-1 27,706

2 32,381 (1+0.10)-2 26,761

3 28,334 (1+0.10)-3 21,288

4 23,858 (1+0.10)-4 16,295
5 45,445 (1+0.10)-5 28,218

$45,268
 Deflation Method (Example 4.6):
Converting actual dollars to constant dollars and then
to equivalent present worth
n=0 n=1 n=2 n=3 n=4 n=5

Actual
Dollars -$75,000 $32,000 $35,700 $32,800 $29,000 $58,000

Constant -$75,000 $30,476 $32,381 $28,334 $23,858 $45,455

Dollars

Present
-$75,000
Worth
$27,706 $26,761 $21,288 $16,295 $28,218

$45,268
 Adjusted-Discount Method
An
Pn 
(1  i ) n
An An An
Step 1 
(1  f ) n (1  i ) n
(1  f )(1  i ') 
n

Pn   
(1  i ' ) n
Step 2 (1  i )  (1  i )(1  i ')
An  1  i ' f  i ' f

(1  f )(1  i ') n


An
(1  f )(1  i ') 
 
n
i  i ' f  i ' f
Example 4.7 Adjusted-Discounted Method
i  i'  f  i' f
 0.10  0.05  (0.10)(0.05)
 15.5%

n Cash Flows in Actual Multiplied Equivalent

Dollars by Present Worth
0 -$75,000 1 -$75,000
1 32,000 (1+0.155)-1 27,706
2 35,700 (1+0.155)-2 26,761
3 32,800 (1+0.155)-3 21,288
4 29,000 (1+0.155)-4 16,296
5 58,000 (1+0.155)-5 28,217
$45,268
Summary
 The Consumer Price Index (CPI) is 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.

 Inflation is the term used to describe a decline

in purchasing power evidenced in an economic
environment of rising prices.

 Deflation is the opposite: An increase in

purchasing power evidenced by falling prices.
Philippine Inflation Rate
Philippine Inflation Rate
 Republic of the Philippines
PHILIPPINE STATISTICS AUTHORITY
Quezon City

Table 1 Monthly Consumer Price Index for All Income Households in the Philippines by Commodity Group
January 2017- December 2018
(2012 = 100)

2018
COMMODITY GROUP Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Ave
ALL ITEMS 114.1 114.9 115.5 116.1 116.1 116.8 117.4 118.4 119.5 119.8 119.6 118.9 117.3
Food and Non-Alcoholic Beverages 119.8 120.4 121.0 121.5 121.4 122.3 123.4 125.4 127.6 127.7 126.8 126.0 123.6
Alcoholic Beverages and Tobacco 170.5 179.6 183.9 186.3 187.8 188.9 190.9 191.6 192.3 193.0 194.0 195.5 187.9
Clothing and Footwear 115.8 116.1 116.3 116.6 116.8 117.0 117.4 117.5 117.8 117.9 118.3 118.5 117.2
Housing, Water, Electricity, Gas, and Other Fuels 107.6 108.7 109.6 110.2 110.0 110.2 111.2 111.4 111.9 112.3 112.2 111.9 110.6
Furnishing, Household Equipment and Routine
Maintenance of the House 114.0 114.5 115.2 115.5 115.7 115.9 116.6 116.9 117.2 117.5 117.9 118.0 116.2
Health 113.9 114.2 114.7 115.1 115.2 115.4 116.8 117.1 117.3 117.7 118.0 118.3 116.1
Transport 101.4 102.8 102.5 103.3 104.3 104.7 105.4 106.2 107.2 108.2 108.8 104.6 105.0
Communication 100.9 100.9 101.0 101.0 101.0 101.1 101.2 101.2 101.3 101.3 101.3 101.3 101.1
Recreation and Culture 111.1 111.2 111.3 111.4 111.5 111.7 112.0 113.8 114.2 114.3 114.4 114.5 112.6
Education 120.0 120.0 120.0 120.0 120.0 124.5 115.3 115.4 115.4 115.4 115.5 115.5 118.1
Restaurant and Miscellaneous Goods and Services 110.8 111.3 112.0 112.4 112.8 113.1 113.5 113.9 114.3 114.5 115.1 115.2 113.2

2017
COMMODITY GROUP Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Ave
ALL ITEMS 110.3 110.7 110.7 111.1 111.0 111.0 111.1 111.3 112.0 112.3 112.8 113.1 111.5
Food and Non-Alcoholic Beverages 114.8 114.9 114.3 114.7 114.8 115.3 115.3 115.6 116.3 116.7 117.4 118.1 115.7
Alcoholic Beverages and Tobacco 152.0 153.7 155.1 155.3 155.8 156.4 157.1 157.6 157.9 158.7 159.3 160.6 156.6
Clothing and Footwear 113.6 113.8 114.0 114.1 114.3 114.5 114.6 114.8 114.9 115.0 115.2 115.3 114.5
Housing, Water, Electricity, Gas, and Other Fuels 104.7 105.9 106.5 107.0 106.8 105.4 105.3 105.6 107.0 107.2 107.7 107.5 106.4
Furnishing, Household Equipment and Routine
Maintenance of the House 111.6 111.8 112.2 112.4 112.4 112.5 112.9 113.0 113.2 113.3 113.4 113.7 112.7
Health 111.6 111.8 112.0 112.0 112.1 112.4 112.6 112.6 112.7 112.8 112.9 112.9 112.4
Transport 97.0 97.3 98.0 98.5 98.2 97.8 97.7 98.5 99.3 99.4 99.9 100.6 98.5
Communication 100.6 100.7 100.7 100.7 100.7 100.7 100.7 100.8 100.8 100.8 100.9 100.9 100.8
Recreation and Culture 109.5 109.7 109.8 109.8 109.9 110.2 111.0 111.0 110.9 110.9 110.9 111.0 110.4
Education 117.9 117.9 117.9 117.9 117.9 119.7 120.0 120.0 120.0 120.0 120.0 120.0 119.1
Restaurant and Miscellaneous Goods and Services 108.4 108.6 108.7 108.7 108.8 109.2 109.4 109.5 109.9 109.9 110.1 110.4 109.3
Practice Problems:
1. Calculate the CPIs ( Consumer Price Index)
:
Goods P2016 P2017 P2018
Socks $4 $5 $4.50
Hotdogs $12 $2.50 $3.0
Burger $10 $13 $12

2. The average unleaded gasoline price for residents of a city on May 30,2011
was $5.20 /gal. assuming that the base period (Price index= 100) is 1996 and
that the unleaded-gasoline price for the year was $2.10/gal., Compute the
average price index for the unleaded gasoline price for the year 2011?
3. The typical household in the X-nation buys 4 loaves of bread, 3 lbs of
cream cheeze, and 8 books each week. The prices of these goods in years
2015, 2016, and 2017 are given in the table below
:
Year P Loaf of bread P lb. of cream cheeze P of a book
2015 $1 $3 $10
2016 $2 $6 $20
2017 $3 $6 $25
Practice Problems:
a). Calculate the CPI in 2017,using 2016 as the base year
b.) Calculate the CPI IN 2015, using 2016 as the base year
c.) Calculate the rate of inflation between 2015 and 2016
d.) Calculate the rate of inflation between 2016 and 2017

4. What would $30,000 earned in 1995 be equal to in 2011? The CPIs for the
two years are 152.4 and 223.47 respectively.

5. An engineer’s salary was $50,000 in 2006. The same engineer’s salary in

2011 is $80,000. If the company’s salary policy dictates that a yearly raise in
salaries reflect the cost of living increase due to inflation,
a.) Calculate the average inflation rate for the period 2006- 2011?
b.) Calculate the average inflation rate for the period 2002- 2011?(assume
average inflation rate in 2002-2006 was 7.89%)

6. Suppose that you borrow $60,000 at 9% compounded monthly over five

years. Knowing that the 9% represents the market interest rate, you compute
the monthly payment in actual dollars as $1,245.51. If the average monthly
general inflation rate is expected to be a 0.25%. Determine the equivalent
equal monthly payment series in constant dollars.
:
Practice Problems:
7. A couple wants to save for their daughter’s college expense. The daughter will
enter college 8 years from now, and she will need $50,000, $51,000,$52,000,
and $53,000 in actual dollars over four school years. Assume that these college
payments will be made at the beginning of each school year. The future general
inflation rate is estimated to be 7% per year, and the annual inflation-free interest
rate is 6%. What is the equal amount in actual dollars ,the couple must save
each year until their daughter goes to college?
8. You just signed a business consulting contract w/ one of your clients. The
client will pay you $80,000 a year for five years for the service you will provide
over this period. You anticipate the general inflation rate over this period to be
5%. If your desired inflation free interest ( real interest rate) is to be 3%, What is
the worth of the fifth (5th) payment in present dollars? The clients will pay the
consulting fee at the end of each year.
9. The annual fuel costs to operate a small solid waste treatment plant are
projected to be $1.8million, without consideration for any future inflation. The best
estimates indicate that the annual inflation-free interest (i’) will be 7% and the
general inflation rate, f =4%. If the plant has a remaining useful life of five (5)
years, what is the present equivalent value of its fuel costs, using actual-dollar
anlysis?
:
Practice Problems:
10.A Series of five (5) constant-dollar ( or real- dollar) payments, beginning with
$8,000 at the end of the first year, are increasing at the rate of 5% per year.
Assume that the average general inflation rate is 5% and the market-interest rate
is 12% during the inflationary period. What is the equivalent present worth of the
series?

:
11. A Couple wishes to establish a college fund at a bank for their five-year old child
The College fund will earn an 8% interest compounded quarterly . Assuming that
the child enters college at 18 , the couple estimates that an amount of $30,000
per year, in terms of today’s dollars ( dollars in child’s age of five), will be
required to support the child’s college expenses for four years. College
expenses are estimated to increase at an annual rate of 6%. Determine the
equal quarterly deposits the couple must make until they send their child to
college . Assume that the first deposit will be made at the end of the first
quarter and that deposits will continue until the child reaches age 17. The child
will enter college at age 18, and the annual college expense will be paid at the
beginning of each college year.In other words, the first withdrawal will be made
when the child is 18.
 Equivalence Calculation with
Composite Cash Flow Elements
Approach:
Convert any cash flow elements in constant dollars
into actual dollars. Then use the market interest rate
to find the equivalent present value.
Age College expenses College expenses
(in today’s dollars) (in actual dollars)

18 (Freshman) $30,000 $30,000(F/P,6%,13) = $63,988

19 (Sophomore) 30,000 30,000(F/P,6%,14) = 67,827

20 (Junior) 30,000 30,000(F/P,6%,15) = 71,897
21 (senior) 30,000 30,000(F/P,6%,16) = 76,211
 Required Quarterly Contributions to College
Funds

V1 = C(F/A, 2%, 48)

V2 = $229,211

Let V1 = V2 and solve

for C:

C = $2,888.48