Chapter 14: Inflation and Price Change
During times of inflation, the purchasing power of a monetary unit is reduced. In this way the
currency itself is less valuable on a per unit basis. In the USA, what this means is that during
inflationary times our dollars have less purchasing power, and thus we can purchase less
products, goods and services with the same $1, $10, or $100 dollar bill as we did in the
Actual dollars are the cash dollars that we use to make transactions in our economy. These
are the dollars that we carry around in our wallets and purses, and have in our savings
accounts. Real dollars represent dollars that do not carry with them the effects of inflation,
these are sometimes called “inflation free” dollars.
Real dollars are expressed as of
purchasing power base, such as Year-2000-based-dollars.
The inflation rate captures the loss in purchasing power of money in a percentage rate form.
The real interest rate captures the growth of purchasing power, it does not include the
effects of inflation is sometimes called the “inflation free” interest rate. The market interest
rate, also called the combined rate, combines the inflation and real rates into a single rate.
There are a number of mechanisms that cause prices to rise. In the chapter the authors talk
money supply, exchange rates, cost-push,
contribute to inflation.
Yes. Dollars, and interest rates, are used in engineering economic analyses to evaluate
projects. As such, the purchasing power of dollars, and the effects of inflation on interest
rates, are important.
The important principle in considering effects of inflation is not to mix-and-match dollars and
interest rates that include, or do not include, the effect of inflation.
A constant dollar analysis
uses real dollars and a real interest rate, a then-current (or actual) dollar analysis uses
actual dollars and a market interest rate. In much of this book actual dollars (cash flows) are
used along with a market interest rate to evaluate projects
this is an example of the later
type of analysis.
The Consumer Price Index (CPI) is a composite price index that is managed by the US
Department of Labor Statistics. It measures the historical cost of a bundle of “consumer
goods” over time. The goods included in this index are those commonly purchased by
consumers in the US economy (e.g. food, clothing, entertainment, housing, etc.).