Module 10: Inflation

SI-4251 Ekonomi Teknik

Muhamad Abduh, Ph.D.
Outline Module 10
 Inflation
 Inflation Rate
 Present Worth Calculation
 Cost Estimation

2 SI-4251 Ekonomi TeknikMuhamad Abduh, Ph.D.

Inflation
 The prices for goods and services are driven upward or downward
because the effect of factors in economy.
 Inflation is term related to the change in price level in economy,
at which the amount of goods and/or services purchased is
reduced for the same amount of money spent.
 Deflation is the term for opposite condition
 Price Index is a ratio used to measure the historical price-level
changes for a particular commodities or general cost of living
(e.g., Consumer Price Index (CPI)
CPI


300

200

100 Year
3 SI-4251 Ekonomi TeknikMuhamad Abduh, Ph.D.
Definitions
 Inflation rate (f)
 Inflation-free interest rate (i)
 Inflated interest rate (if)

4 SI-4251 Ekonomi TeknikMuhamad Abduh, Ph.D.

Inflation Rate
 The rate of inflation (+f) (or deflation (-f)) is calculated
based on changes in prices in successive years. This
rate has a compounding effect.
 Inflated interest, i f = i + f + if

 Annual inflation rate for year (t+1)
CPI ( t +1) − CPI ( t )
 f =
 CPI ( t )


 Dollars in period t1
$( t 2 )

$ t1 =
 Inflationt1−t 2
 Today’s dollar
 $( t 2 )
$t 1 =
 (1 + f ) n

5 SI-4251 Ekonomi TeknikMuhamad Abduh, Ph.D.
 Present Worth Calculation using Today’s Dollars
 An item that cost $ 1,000 today is subjected to
10% rate of inflation and 8% of interest

(1) (2) (3) (4) = (3)/(1+f)n (5) = (4)(P/F, i, n)
EOY Cost increase due Future cost in Future Present worth
0 1,000 1,000 cost in today’s 1,000
to inflation then dollars dollar
1 100 1,100 1,000 925
2 110 1,210 1,000 857.3
3 121 1,331 1,000 793.8

6 SI-4251 Ekonomi TeknikMuhamad Abduh, Ph.D.

Present Worth Calculation using Inflated
Rate
 An item that cost $ 1,000 today is subjected
to 10% rate of inflation and 8% of interest
 Inflated interest rate, if = I + f + if = 0.08 +
0.1 + 0.1*0.08 = 0.188 (18.8%)

(1) (2) (3) (4) = (3)(P/F, if, n)

EOY Cost increase due to Future cost in then Present worth
0 1,000 1,000
inflation dollars
1 100 1,100 925.9
2 110 1,210 857.3
3 121 1,331 793.8

7 SI-4251 Ekonomi TeknikMuhamad Abduh, Ph.D.

Exercises
1. Bambang is scheduled to receive Rp.50 million payment from a
trust fund 10 years from now. The inflation rate is estimated at
an average of 6% annually. Find the constant value (Rp)
equivalent of this payment if the constant-Rp base is (a) t = 0,
(b) t = 5 , and (c) t = -3 (three year prior to the present)
2. A payment of Rp 200 millions is to be received 8 years from now,
followed by additional Rp 150 millions 10 years afterward.
Alternatively, a sum of Rp 320 millions can be received at the
end of 15 years. If the annual rate of inflation is 5% and interest
rate is estimated at 9%, which installment is preferred, constant
dollars analysis
3. The following shows the consumer price index recorded over the
period of 9 years
 Year CPI Year CPI Year CPI
 1995 1.7 1998 3.1 2001 2.6
 1996 1.9 1999 2.7 2002 2.9
 1997 1.8 2000 2.5 2003 2.9

8 determine the inflation rate at year
SI-4251 1998,
Ekonomi 2000,
Teknik and 2002
Muhamad Abduh, Ph.D.

Cost Estimation
 Cost at any point in time can be estimated using
comparison of cost at any other time
 Cost Index is a ratio of the cost of an item today to
the cost at some point in Itime

t
Ct = C 0
 I0
 Ct = estimated cost at present time t
 C0 = cost at base time t0
 It = index value at time t
 I0 = index value at time t0


 Cost Capacity Factor is a ratio of a certain volume

to the other volume
x
Q 



C2 = C1  2 
C2 = estimated cost at capacity QQ
 2
1 


 C1 = cost at capacity Q1
 Q1 = capacity 1
 Q2 = capacity 2
 x = capacity factor , exponent , varies depending type of product

9 SI-4251 Ekonomi TeknikMuhamad Abduh, Ph.D.

Exercises
1.An investor is considering to build a new oil refinery plant
with the capacity of 800,000 barrel per day (bpd). 15
years ago a similar plant with a capacity of 700,000 bpd
was built for US$ 575 million. If the inflation is estimated
at 4% annually, what is the estimated cost for building
the new plant? Cost capacity index for oil refinery is
0.64
2.An item is bought for Rp7,5 million five years ago when the
consumer price index is recorded at 112 point. Today,
when the index is calculated at 119, what is the
estimated cost of the same item?
3.What will be the value of a bulldozer cost index in 2010 if it
was 276.5 in 2003, when it increases 6% a year?


10 SI-4251 Ekonomi TeknikMuhamad Abduh, Ph.D.