Lecture4 - 47 L ECTURE 4 T IME V ALUE OF M ONEY AND I...

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Unformatted text preview: 47 L ECTURE 4 T IME V ALUE OF M ONEY AND I NFLATION Reading: Chapter 4: pp. 134-145 Practice Problems: online problems, plus problems at the end of the notes. Objectives: Explain the difference between nominal and real dollars Convert between nominal and real interest rates Solve present value and annuity problems in real terms 48 I NFLATION : N OMINAL AND REAL DOLLARS Holding constant the quality of goods, inflation is measured by a percentage increase in the price of a representative basket of goods and services. In the U.S. the consumer price index (CPI) measures the change in purchasing power of dollars. The percentage change in the consumer price index is the rate of inflation. The CPI is calculated as the total price of a group of goods that a typical consumer would purchase (e.g. food, gasoline, etc.). If this group of goods costs $100 last year and the same goods cost $105 this year, then inflation is 5%. Prices have risen by 5%. The purchasing power of a dollar has decreased. Say your income grows by 10% per year, but inflation is 5% per year. Year CPI Rate of inflation Real value of $1.00 Nominal income (growth = 10%) Real income 0 100.00 $1.00 $10,000 $10,000 1 105.00 5.0% $0.9524 $11,000 $10,476 2 110.25 5.0% $0.9070 $12,100 $10,975 Inflation is the loss in purchasing power of a currency. CPI 20 40 60 80 100 120 140 160 180 200 1 9 3 9 1 9 4 1 1 9 4 3 1 9 4 5 1 9 4 7 1 9 4 9 1 9 5 1 1 9 5 3 1 9 5 5 1 9 5 7 1 9 5...
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This note was uploaded on 12/02/2009 for the course FIN 350 taught by Professor Schonlau during the Spring '08 term at University of Washington.

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Lecture4 - 47 L ECTURE 4 T IME V ALUE OF M ONEY AND I...

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