Engineering Economic Analysis

Meaning and Effect of Inflation 441

owing to fluctuations in exchange rates, prices may be raised in other markets to

compensate.

Cost-push inflation:This type of inflation develops as producers of goods and ser-

vices "push" their increasing operating costs along to the customer through higher

prices. These operating costs include fabrication/manufacturing,marketing, and

sales.

Demand-pull inflation:This effect is realized when consumers spend money freely on

goods and services. Often "free spending" is at the expense of consumer saving.

As more and more people demand certain goods and services, the prices of those

goods and services will rise (demand exceeding supply).

Afurther considerationin analyzinghowinflationworksistheusuallydifferentratesat

which the prices of goods and services rise versus the wagesof workers.Do workers benefit

if, as their wages increase, the prices of goods and servicesincrease, as well? To determine.

the net effect of differing rates of inflation, we must be able to make comparisons and

understand costs and benefits from an equivalent perspective. In this chapter's examples,

wewilllearnhowto makesuchcomparisons.

Definitions for Considering Inflation in Engineering Economy

The following definitions are used throughout this chapter to illustrate how inflation and

price change affect two quantities: interest rates and cash flows.

Inflation rate (I): As suggested earlier, the inflationrate captures the effect of goods

and services costing more-a decrease in the purchasing power of dollars. More

money is required to buy a good or service whose price has inflated. The inflation

rate is measured as the annual rate of increase in the number of dollars needed to

pay for the same amount of goods and services.

Real interest rate (if): Thisinterest rate measures the "real" growth of our moneyex-

cluding the effect of inflation. Because it does not include inflation, it is sometimes

called theinflation-free interest rate.

Market interest rate (i): This is the rate of interest that one obtains in the general

marketplace. For instance, the interest rates on passbook savings, checking plus,

and certificates of deposit quoted at the bank are all market rates. The lending

interest rate for autos and boats is also a market rate. This rate is sometimes called

thecombined interestrate because it incorporates the effect of both real money

growth and inflation. We can viewias follows:

Market

interest

rate

Effect

of

inflation

"Real"

growth

of money

has in it and

;'1"

'!

• I,I
  rII
  I
  ,."',.

!

;j"