Engineering Economic Analysis

440 INFLATION AND PRICECHANGE l

I

Thusfarwehaveassumedthat dollars in our analyseswereunaffectedby inflationor price

change. However,this assumption is not always valid or realistic. If inflation occurs in the

general economy, or if there are price changes in economic costs and benefits, the impact

can be substantial on both before- and after-tax analyses. In this chapter we develop several

key concepts and illustrate how inflation and price changes may be incorporated into our

problems.

Meaning and Effect of Inflation 14 INFLATIONAND PRICE CHANGE

Inflationis an importantconcept because the purchasingpowerof money used in most world

economies rarely stays constant. Rather, over time the amountof goods and services thatcan

be purchased with a fixedamount of money tends to change. Inflation causes U.S. dollars to

losepurchasing power.Thatis, whenpricesinflatewe canbuylesswiththe sameamount.

of money.Inftation inakes future dollars less valuable than present dollars. Think about

examples in your own life, or for an even starker comparison, ask your grandparents how

much a loaf of bread or a new car cost 50 years ago. Then compare these prices with what

you would pay today for the same items. This exercise will reveal the effect of inflation:as

time passes, goods and services cost more, and more of the same monetaryunits are needed

to purchase the same goods and services.

Because of inflation, dollars in one period of time are not equivalent to dollars in

another. We know from our previous study that engineering economic analysis requires

that comparisons be made on an equivalent basis. So, it is important for us to be able to

incorporate the effects of inflation in our analysis of alternatives.

When the purchasing power of a monetary unitincreasesrather than decreases as

time passes, the result is deflation. Deflation, very rare in the modern world, nonetheless

potentially exists. Deflation has the opposite effect of inflation-one can purchase more

with money in future years than can be purchased today. As such, deflation makes future

dollars more valuable than current dollars.

How Does InflationHappen?

Economists do not agree on all the sources of inflation, but most believe that the following

effects influence inflation either in isolation or in combination.

Money supply:The amount of money in our national economy is thought to have an

effect on its purchasingpower.If there is too much money in the system (theFederal

Reserve controls the flow of money) versus goods and services to purchase with

that money,the value of dollars tends to decrease. When there are fewer dollars in

the system, they become more valuable.The Federal Reserve, through its influence

on the money supply, seeks to increase the volume of money in the system at the

same rate that the economy is growing..

Exchange rates:The strength of the U.S. dollar in world markets affects the prof-

itability of international companies in those markets. Price rates may be adjusted

to compensate for the relative strength or weakness of the dollar in the world

market. As corporations' profits are weakened or eliminated in some markets

------ .-------.

------- -- --