Engineering Economic Analysis

Meaning and Effectof Inflation 447

l_- ~-
I

~~ -

In 1924 Mr. O'Leary buried$1000 worthof quartersin his backyard.Over the yearshe had

always thought that the money would be a nice nest egg to give to his first grandchild.His first

granddaughter, Gabrielle, arrived in 1994. At the time of her birth Mr. O'Leary was taking an

economic analysis course in his spare time. He had learned that over the years 1924 to 1994,

inflation averaged4.5%, the stock market increased an average of 15% per year, and investments

in guaranteed government obligations averaged 6.5% return per year. What was the relative

purchasing power of the jar of quarters that Mr. O'Leary gave to his granddaughterGabrielle at

the time of her birth? What might have been a better choice for his "backyard investment?"

SOLUTION!

Mr. O'Leary's $1000 dollars areactual dollarsin both 1924andin 1994.

To obtain thereal 1924-baseddollar equivalentof the $1000 that Gabrielle receivedin 1994

wewouldstrip70yearsof inflationoutofthosedollars.Asit turnedout,Gabrielle'sgrandfather

gave her $45.90 worth of 1924 purchasing power at the time of her birth. Because inflation has

"stolen" purchasing power from his stash of quarters during the 70-yearperiod, Mr. O'Leary gave

his grandaughter much less than the amount he first spaded underground. This loss of purchasing

power caused by inflation over time is calculated as follows:

Real 1924-based dollars in 1994=(Actual dollars in1994)(P1F, t, 1994 - 1924)

=$1000(P/F,4.5%,70) $45.90

On the other hand, if Mr. O'Leary had put his $1000 in the stock market in 1924,he would have

madebaby Gabriellean instantmultimillionaireby givingher $17,735,000.Wecalculatethis as

follows:

Actual dollars in 1994=(Actual dollars in1924)(F1P, i,1994- 1924)

=$1000(FI P,-15%,70) = $17,735,000

At the tiple of Gabrielle's birth that $17.7 million translates to $814,069 in 1924 purchasing

power. This is quite a bit different from the $45.90 in 1924 purchasing power calculated for the

unearthed jar of quarters.

Real 1924-based dollars in 1994=$17,735,OOO(P1F,4.5%, 70)=$814,069

Mr. O'Leary was never a risk taker, so it is doubtfulhe would have chosen the stock IDarketforhis

future gJ:IDIdchild'snest egg. If he had chosen guaranteed government obligations instead of his

backyard, by 1994 the investmentwould have grown to $59,076 (actual dollars)-the equivalent

of $271~ in 1924 purchasing power.I "

~= ~= Actuahiollars'in 1994~ ""(Acttial dollars in 1924)(F 1 P/i,1994~ 1924)

~I .. $1OO0(FIP,6%, 70) = $59,076

~ 'Real 1924-basetl'dollafsihr994'~~$59',076'(~:PllIp,4.5%,70)---$2712'

1:1 c 'III II

---

I

I"

I

j rI

!

""';J

1

....