Engineering Economic Analysis

l

444 INFLATION ANDPRICECHANGE -

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base(t)$ at(t)~

fforO

periods A$at(t)~

I

t

i' ~ Rbase(t)$ at

::J

n)

ffor the

n tpe'od

~A$at(n) - n,

I

n

Time

FIGURE 14-1 Relationship betweeni, f, i', A$,andR$.

Real dollars (R$): These dollars are a bit harder to define. They are always expressed'

in terms of some constant purchasing power "base" year, for example, 2002-based

dollars. Real dollars are sometimes calledcQnstantdollarsorconstantpurchasing

power dollars,and because they do not carry the effects of inflation, they are also

known asinflation-freedollars..

Having definedmarket, inflation,andreal interest ratesas well asactualandreal

dollars,let us describe how these quantities relate. Figure 14-1 illustrates the relationship

between these quantities.

Figure 14-1 illustrates the following principles:

When dealingwith actual dollars(A$),use a market interestrate(i),and when dis-

countingA$overtime, alsousei.

When dealing with real dollars(R$),use a real interest rate(i'),and when discounting

R$over time, also usei'.

Figure 14-1 shows the relationships betweenA$andR$that occurat the same period of

time.Actual and real dollars are related by theinflation rate,in this case, over the period

of years defined byn-t.To translate between dollars of one type to dollars of the other

(A$toR$orR$toA$)use the inflation rate for the appropriate number of periods. The

following example illustrates many of these relationships.

'!J:!. ''51: - __-'

Aurrivers!tyis considering replacing its staqiUl]1with a new facjlity~,When the prese:ntbuil4ing

w~s completed in 1950, the total co§t was $1.2 million. At that time a wealthy alumnus gifted

the u~iversity with $1.2 rhinion to beuse{l for a funire replacement.. University administrators are

ncr considering building the new facility in the year 2Q05..

AJ~sumethe following:

~I ·Inflation is 6:0% perye~ troIn.i;9~Pto 2005.

II. In 19~0 the universityiny~~l¥t4~gi{t ata:lp.ar,ketjritere~trateof 8.Q%per year.

=' ;:;;===II:=:<",.,..~=,~,~'~,:;"~'-""

~

n/ "'='~~;-=<i-:!J!:I--""",.q.- ~- - - - =- - c--

()Dfi

,'. "

f$

'

dfr

~ '

ill

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  II .a e nel, l" ,A ~an.I.J..,"..Qm,.e pr6 em,.
  (b) How Inany flctual dolr~ji;vth~ye .'~.~OQ5 will tl.1egift be Worth?
  (c) flow much wouldthe~~~tYA~4!:iilai~il}2005 be in t~nns,<:>t.1950purchasing power?
  i'~ " ","~)~e,:,¥&::~;'::?~y--'<",-~--'.. ' __.""- ~~ -

...

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