Module 10: Inflation
SI-4251 Ekonomi Teknik
Muhamad Abduh, Ph.D.
Outline Module 10
Inflation
Inflation Rate
Present Worth Calculation
Cost Estimation
10-2 SI-4251 Ekonomi Teknik Muhamad Abduh, Ph.D.
Inflation
The prices for goods and services are driven upward or downward because the
effect of factors in economy.
Inflation is term related to the change in price level in economy, at which the
amount of goods and/or services purchased is reduced for the same amount of
money spent.
Deflation is the term for opposite condition
Price Index is a ratio used to measure the historical price-level changes for a
particular commodities or general cost of living (e.g., Consumer Price Index (CPI)
CPI
300
200
100 Year
10-3 SI-4251 Ekonomi Teknik Muhamad Abduh, Ph.D.
Definitions
Inflation rate (f)
the annual percentage of increase in prices of goods or services
Inflation-free interest rate (i)
represents the earning power if money with the effect of inflation removed
Inflated interest rate (if)
represents the rate of interest (earning power of money) with inflation considered
10-4 SI-4251 Ekonomi Teknik Muhamad Abduh, Ph.D.
Inflation Rate
The rate of inflation (+f) (or deflation (-f)) is calculated based on changes in prices in
successive years. This rate has a compounding effect.
Inflated interest,
i f i f if
Annual inflation rate for year (t+1)
CPI t 1 CPI t
f
CPI t
Dollars in period t1 $ t 2
$t1
Inflation t1t 2
Today’s dollar $ t 2
$t 1
1 f n
10-5 SI-4251 Ekonomi Teknik Muhamad Abduh, Ph.D.
Present Worth Calculation using Today’s Dollars
An item that cost $ 1,000 today is subjected to 10% rate of
inflation and 8% of interest
(1) (2) (3) (4) = (3)/(1+f)n (5) = (4)(P/F, i, n)
EOY Cost increase Future cost Future cost in Present worth
due to in then today’s dollar
inflation dollars
0 1,000 1,000 1,000
1 100 1,100 1,000 925
2 110 1,210 1,000 857.3
3 121 1,331 1,000 793.8
10-6 SI-4251 Ekonomi Teknik Muhamad Abduh, Ph.D.
Present Worth Calculation using Inflated Rate
An item that cost $ 1,000 today is subjected to 10% rate
of inflation and 8% of interest
Inflated interest rate, if = I + f + if = 0.08 + 0.1 + 0.1*0.08
= 0.188 (18.8%)
(1) (2) (3) (4) = (3)(P/F, if, n)
EOY Cost increase due Future cost in Present worth
to inflation then dollars
0 1,000 1,000
1 100 1,100 925.9
2 110 1,210 857.3
3 121 1,331 793.8
10-7 SI-4251 Ekonomi Teknik Muhamad Abduh, Ph.D.
Exercises
1. Bambang is scheduled to receive Rp.50 million payment from a trust fund 10 years
from now. The inflation rate is estimated at an average of 6% annually. Find the
constant value (Rp) equivalent of this payment if the constant-Rp base is (a) t = 0,
(b) t = 5 , and (c) t = -3 (three year prior to the present)
2. A payment of Rp 200 millions is to be received 8 years from now, followed by
additional Rp 150 millions 10 years afterward. Alternatively, a sum of Rp 320
millions can be received at the end of 15 years. If the annual rate of inflation is 5%
and interest rate is estimated at 9%, which installment is preferred, constant dollars
analysis
3. The following shows the consumer price index recorded over the period of 9
years
Year CPI Year CPI Year CPI
1995 1.7 1998 3.1 2001 2.6
1996 1.9 1999 2.7 2002 2.9
1997 1.8 2000 2.5 2003 2.9
determine the inflation rate at year 1998, 2000, and 2002
10-8 SI-4251 Ekonomi Teknik Muhamad Abduh, Ph.D.
Cost Estimation
Cost at any point in time can be estimated using comparison of cost at any
other time
Cost Index is a ratio of the cost of an item today to the cost at some point in
time C C t
I
t 0
I0
Ct = estimated cost at present time t
C0 = cost at base time t0
It = index value at time t
I0 = index value at time t0
Cost Capacity Factor is a ratio of a certain volume to the other volume
x
Q
C2 C1 2
C2 = estimated cost at capacity Q2
C1 = cost at capacity Q1
Q1
Q1 = capacity 1
Q2 = capacity 2
x = capacity factor, exponent, varies depending type of product
10-9 SI-4251 Ekonomi Teknik Muhamad Abduh, Ph.D.
Exercises
1. An investor is considering to build a new oil refinery plant with the
capacity of 800,000 barrel per day (bpd). 15 years ago a similar plant with
a capacity of 700,000 bpd was built for US$ 575 million. If the inflation is
estimated at 4% annually, what is the estimated cost for building the new
plant? Cost capacity index for oil refinery is 0.64
2. An item is bought for Rp 7,5 million five years ago when the consumer
price index is recorded at 112 point.Today, when the index is calculated
at 119, what is the estimated cost of the same item?
3. What will be the value of a bulldozer cost index in 2010 if it was 276.5 in
2003, when it increases 6% a year?
10-10 SI-4251 Ekonomi Teknik Muhamad Abduh, Ph.D.
