Inflation

Inflation

Inflation is an increase in the amount of money necessary to purchase the same quantity of goods or services prior to the inflated price. It occurs when the value of currency decreases, meaning more currency is required to obtain the same goods or services. When making comparisons between monetary amounts across different time periods, it is important to convert the different-value dollars to constant-value dollars to represent the same purchasing power. Purchasing power refers to the value of currency based on the quantity and quality of goods or services one unit of money can buy. Inflation reduces purchasing power, as fewer goods or services can be purchased for the same amount of money. Inflation is a formidable force in our economy.

Types of Inflation

Cost-Push Inflation	Demand-Pull Inflation
Caused by an increase in production costs (inputs).	Caused by an increase in overall demand for goods and services.
Triggered by rising energy costs, scarcity of materials, and higher wages.	Driven by higher money supply, increased income levels, and strong consumer demand.
Leads to reduced supply as production becomes more expensive.	Demand grows faster than supply, creating shortages.
Businesses pass higher costs to consumers, raising prices.	Prices rise as excessive demand pushes them up.
Example: An oil price hike increases transportation costs, raising product prices.	Example: Government stimulus boosts consumer spending, driving demand and prices up.

Causes of Inflation

Increased money supply: When the money supply increases without a corresponding increase in goods and services, the value of currency decreases, leading to inflation.
Government overspending: Overspending by the government can lead to hyperinflation.
Weak international trade balances: Weak trade balances can contribute to hyperinflation.
Political instability: Political instability can cause hyperinflation.
Market risks Interest rates can significantly impact the costs of financing a project, corporate cash flows, and asset values.
Global economics Governments and corporations operate in economic and financial environments with some levels of uncertainty and instability.
Earning power of money The earning power of money involves prices of goods and services that can move upward or downward, where the purchasing power of money can change with time. Both price reductions and price increases can occur where reductions are caused by increases in productivity and availability of goods, and increases are caused by government policies, price support schemes, and deficit financing.
World events Hikes in oil prices can greatly affect commodity prices and pose serious challenges to countries and corporations.
Fiscal and monetary expansion An assessment of the effect of the government’s spending, taxing, interest rate, and other monetary policies. The assessment is based on a judgment as to whether the expansion is inadequate for a healthy business climate, acceptably expansionist, or so excessively expansionist as to threaten inflation or other economic disorder.

Measuring Inflation

Economists developed the Consumer Price Index (CPI), which is based on a typical market basket of goods and services required by the average consumer. It consists a market basket with 8 groups of goods and services. This includes:

Food and alcoholic beverages
Housing
Apparel
Transportation
Medical care
Entertainment
Personal care
Other goods and services

PPI $⟹$ Procedure Price Index

The Producer Price Index captures price changes over time for a specific commodity or industry.
Based for industrial price increase measure.

Types of Inflation Rates

General Inflation Rate: An average inflation rate calculated using the CPI for all items in the market basket. The market interest rate is expected to respond to the general inflation rate.
Specific Inflation Rate: The average inflation rate for specific goods.

Constant-Value vs. Future Dollars

Constant-value dollars (CV), also called today’s dollars, represent the value of money in period t1.
Future dollars, also called inflated or then-current dollars, represent the value of money in period t2.

To convert future dollars to constant-value dollars, the following formula can be used:

$LaTeX: \text{Constant Value Dollar}=\frac{\text{Future Dollar}}{(1+f)^{n}}$

where, n = period in years
f = inflation rate

Interest Rates and Inflation

Real Interest Rate (i):
Reflects the true earning power of money when the effects of inflation have been removed.
Inflation Rate (f):
Measures the rate of change in the value of currency.
Market Interest Rate (if):
Includes both the real interest rate and the expected inflation rate.

The relationship between these rates is: if = i + f + (i x f)

Inflation in contract management:

In general practice as per PPA and PPR for contracts with period greater than 12 months price is adjusted for the rates/amount as quoted or offered by the contractor. We use a formulae and different factors that account for labour, equipment, materials, etc. (Note: there is a provision where price can be adjusted even for periods less than 12 months when there is 10% change in the price of a material/service). Based on inflation attractors gets extra money. When different cost components (labor, material, fuel, etc.) fluctuate separately the typical way of adjusting prices is given below.

$P_t = P_0 \times \left( a + b \times \frac{L_t}{L_0} + c \times \frac{M_t}{M_0} + d \times \frac{F_t}{F_0} \right)$

$a, b, c, d$ = coefficients representing different cost components,
$L_{t}$ , $M_{t}$ , $E_{t}$ are current labor, material, and equipment costs,
$L_{0}$ , $M_{0}$ , and $E_{0}$ are base costs

Methods for Handling Inflation in Economic Analysis

There are two primary methods for incorporating inflation into economic analysis:

Constant-Dollar Analysis: All cash flow elements are given in constant dollars, and the inflation-free interest rate (i’) is used to account for the earning power of money.
Actual-Dollar Analysis: All cash flow elements are estimated in actual dollars, and the market interest rate (i) is used. This method accounts for both the earning power of money and the effect of inflation.

Deflation

Deflation is the opposite of inflation; it occurs when the purchasing power of money is greater in the future than at present. With deflation, fewer dollars are needed in the future to buy the same amount of goods or services compared to today. Deflation is not as common as inflation, especially at the national level.

Hyperinflation

In a hyperinflated environment, people usually spend their money immediately because the cost of goods and services will be much higher later. Traditional engineering economy methods may not be reliable for making economic decisions in a hyperinflated economy because estimated future values are unreliable, and the future availability of capital is uncertain.

Curriculum

Types of Inflation Rates

Constant-Value vs. Future Dollars

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