IOE+201+Notes+6

# IOE+201+Notes+6 - Actual Dollars versus Constant Dollars...

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1 Actual (current) dollars ( A n ) Represent cash for year n actually received or paid at the time of a cash flow transaction. Constant (real) dollars ( A n ) Represent cash for year n in terms of constant purchasing power at a given base year. Measure of worth, not of actual dollars received or paid. Hypothetical purchasing power of future dollars at base year Actual Dollars versus Constant Dollars n n n f A A ) 1 ( + = n n n f A A ) 1 ( + = where is the general inflation rate f

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2 Actual Dollars versus Constant Dollars 38 . 86 \$ ) 05 . 0 1 ( 100 \$ ) 1 ( 3 = + = + = n n n f A A Example: Base year = 0 Future year n = 3 Actual dollars A n = \$ 100 f General inflation rate = 5% per year Constant dollars A n = \$100 in year 3 is worth only \$86.38 in constant dollars at base year (year 0)
3 Inflation: Interest Rates Market interest rate ( i ) Interest rate taking into account earning power and inflation Inflation-free interest rate ( i ) Interest rate for earning power with inflation effects removed n n i A P ) 1 ( + = Using market interest rate i : Present worth n n i A P ) 1 ( + = Using inflation-free interest rate i : Present worth n n n f A A ) 1 ( + = where A n = actual dollars (e.g., \$100) = constant dollars (e.g., \$86.38) = + = 38 . 86 \$ ) 05 . 0 1 ( 100 \$ e.g., 3 n A n A Present worth of year n dollars:

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IOE+201+Notes+6 - Actual Dollars versus Constant Dollars...

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