Chapter 4 Inflation and its impact on project cash flows
After completing this chapter, you should understand the following concepts:
How to measure inflation
Conversion from actual dollars to constant dollars or from constant to actual dollar.
How to compare the amount of dollars received at different points in time
Which inflation rate to use in economic analysis
Which interest rate to use i economic analysis
How to handle multiple inflation rates in project analysis
The cost of borrowing and changes in working capital requirements under inflation
How to conduct rate of return analysis under inflation
4-1 Meaning and measure of inflation
Historically, the general economy has usually fluctuated in such a way as to exhibit 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 to put it another way, the same dollar amount buys less of an item over time. Deflation is the opposite of inflation in that prices usually decrease over time; hence, a specified dollar amount gains in purchasing power. Inflation is far more common than deflation in the real world, so our consideration in this chapter will be restricted to accounting or inflation in economic analyses.
Measuring inflation
Before we can introduce inflation into an engineering economic problem, we need a means of isolating and measuring its effect. Consumers usually have a relative, if not a precise, sense of how their purchasing power is declining. This sense is based on their experience of shopping for food, clothing, transportation, and housing over the years. Economics have developed a measure called the Consumer Price Index, which is based on a typical market basket of goods and services required by the average consumer. This market basket normally consists of items from eight major groups: food and alcoholic beverages, housing, apparel, transportation, medical care, entertainment, personal care and other goods and services.
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