ENGG 401 X2 Fundamentals of Engineering Management Spring 2008 Extra Material: Inflation Dave Ludwick Dept. of Mechanical Engineering University of Alberta

Dave Ludwick, Dept. of Mech. Eng. Inflation Summer ENGG 401 X2 – Fundamentals of Engineering Management Revisiting Inflation InflationInflation is the concept where as time moves forward, the purchasing power of money decreases. –A dollar tomorrow will buy less than it does today. In Canada, inflation is often measured by the Consumer Price Index (CPI) real nominalmarketThe real interest rate realized by a lender is often given as the difference between the interest rate paid by the borrower (nominal or market interest rate) and inflation (f): only an approximation –…but this is only an approximation.

Dave Ludwick, Dept. of Mech. Eng. Inflation Summer ENGG 401 X2 – Fundamentals of Engineering Management Real Interest A more accurate calculation of real interest rate is:

Dave Ludwick, Dept. of Mech. Eng. Inflation Summer ENGG 401 X2 – Fundamentals of Engineering Management Inflation Example #1 You put $1000 into an account with an interest rate of 12%. How much money will you have 5 years from now and what will its purchasing power be if inflation is 5% per year? –Actual money: –Purchasing power:

Dave Ludwick, Dept. of Mech. Eng. Inflation Summer ENGG 401 X2 – Fundamentals of Engineering Management Actual versus Real Dollars Actual dollarsActual dollars are the money we ordinarily think of. They are the amount of money in an account, in your wallet, etc. –The first part of the last example is asking about actual dollars. Real dollarsReal dollars, on the other hand, are a more abstract concept. They are defined relative to an equivalent sum at an earlier point in time. –The second part of the last example is asking about real dollars. Actual dollars (also called inflated dollars) have their value reduced due to inflation, while real dollars (inflation-free dollars) do not.

Dave Ludwick, Dept. of Mech. Eng. Inflation Summer ENGG 401 X2 – Fundamentals of Engineering Management Inflation In-Class Problem #1 Your city spent $2.5 million to build a public facility 50 years ago, and put aside an equal sum at the same time for its eventual replacement. The money was invested in an account earning 8% interest, and inflation has been 6% per year. Questions: –What are the actual and real dollars of the investment? –What value facility will the city be able to purchase? –What value facility will the city be able to purchase relative to dollars from 50 years ago? –Will the city be able to purchase an equivalent facility today and still put aside enough money to replace it in the future?

Dave Ludwick, Dept. of Mech. Eng. Inflation Summer ENGG 401 X2 – Fundamentals of Engineering Management Inflation In-Class Problem #2 On the birth of your first child, you decide to put aside money for her first year’s tuition to the UofA. Tuition is currently $5400 per year, and the provincial government just passed legislation mandating that tuition increases are tied to inflation (projected to be 3.5%). –What lump sum do you need to invest today in a GIC paying out 5% interest to cover her first year of tuition 18 years from now? –What if you found a way to put a monthly sum into her account which paid 2%. What monthly payment would you need to make?