11%20-%20Price%20Changes

# 11%20-%20Price%20Changes - Engineering Economics ECO 1192...

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Engineering Economics ECO 1192 Lecture 11: Price Changes Claude Théoret University of Ottawa

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ECO 1192A -- Fall 2009 11. Price Changes 2 Recommended Reading Fraser et al. Chapter 9 Newnan et al. chapter 14
ECO 1192A -- Fall 2009 11. Price Changes 3 Introduction CIn all project analyses thus far, the prices of all goods and services were constant. CIn the real world, prices are not constant, sometimes increasing (inflation) and sometimes decreasing (deflation) CPrice changes can have significant effects on the value or worth of an investment; hence, they must be factored in an engineering economic study

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ECO 1192A -- Fall 2009 11. Price Changes 4 Measuring Inflation Consumer Price Index basket of consumer goods and services used to track changes in prices on a monthly basis CWholesale Price Index (tracks the prices of wholesale goods) GDP Implicit Price Deflator (tracks price changes for all final goods and services produced by an economy) Published quarterly and annually
Consumer Price Index (CPI)

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Your house …. Purchased in 1990 for \$150,000 Market value in 2005 (15 years later) is \$225,000 The annual inflation rate has been, on average, 2%. Did your purchasing power increase between 1990 and 2005? Real value of your house in 2005 in 1990 dollars = \$225,000(1+inflation rate) -15 = \$225,000(1+0.02) -15 = \$167,178 Answer: YES (real value in 2005 > real value in 1990).
ECO 1192A -- Fall 2009 11. Price Changes 7 Example: John and Mary John and Mary married five years ago following their graduation from U of O. Their joint income in their first year as a couple was \$80,000. the CPI for that year was (hypothetically) 105.8 Five years later, the CPI reached 133.9. What must be the joint income of the couple to maintain the purchasing power of 5 years earlier?

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ECO 1192A -- Fall 2009 11. Price Changes 8 Bonds and Inflation \$60,000 10-year Canada bonds are currently on sale by Speedy Brokers Inc. The rate of interest is 8% annually, payable semiannually. Bondholders expect A return of 6% per year compounded semiannually Inflation to be constant at 2% every 6 months. How much should a purchaser pay Without any adjustment for inflation When inflation is considered
ECO 1192A -- Fall 2009 11. Price Changes 9 Example: Bond Rates of Return A bond has a current price of \$90,000 pays \$10,000 annually for 10 years If inflation is expected to be 5% forever 1. What is the bond’s actual before-tax rate of return? 2. What is the bond’s actual after-tax rate of return if the tax rate is 30%? 3. What is the bond’s real before-tax rate of return? 4. What is the bond’s real after-tax rate of return if the tax rate is 30%?

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ECO 1192A -- Fall 2009 11. Price Changes 10 Causes of Inflation Money supply Growth in the money supply (currency and bank deposits) exceeds the growth of goods and services Exchange rates Value of one currency in terms of another currency;
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11%20-%20Price%20Changes - Engineering Economics ECO 1192...

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