### ! Notes on INFLATION

Inflation is the effect that causes the price of a good or service to increase in monetary units over time. During the period the value. The opposite effect is deflation, i.e. negative inflation. Over long periods of time the historical record shows that inflation is a persistent but unsteady effect.

The inflation rate tends to be compounded because it is generally calculated as a percentage of the previous period. Forecasting inflationary effects is uncertain and especially difficult for extended periods. Inflationary effects vary considerably from country to country at the same times. They are effected by national monetary policy and other factors such as trading in national currencies.

Inflation is an effect like income taxes that must be considered in every realistic time value analysis. The analysis is easier if you ignore inflationary effects. However the chance of the analysis leading to a serious error is increased if inflation or any other persistent effect is ignored.

E.g. To estimate the Present Value (P) of a fund required to produce a series of payments for a pension or other maintenance expenditures it is necessary to account for:

· Return on investment (i)

· Inflationary effects (j)

· Number of payments (n)

The following example uses fairly long series to illustrate the effects over extended periods of time. For realistic problems a calculator that will deal easily with the long series is helpful.

The example illustrates some of the calculations that could be used to determine the payments for a personal retirement income fund. Any examination of historical income data will show the effects of inflation. These may not be repeated, but the trends should not be ignored.

Choose a beginning annual retirement income = R. This is estimated to continue for M years. The estimated long term inflation rate = j

The inflated amount required for each year (y) in the future = R x (1+j)y. Values can be generated for years 0 to M.

·  Use: R=\$50,000; M=20 years (i.e. 65 to 85); j=3% per year. (The following values were computed using APL, and rounded to nearest dollar.)

50000     51500     53045     54636     56275
57964     59703     61494     63339     65239
67196     69212     71288     73427     75629
77898     80235     82642     85122     87675

The Computed values can be discounted to a (Present) value at the beginning of the series. A long term return on investment would establish the appropiate discount rate. For this example assume i=6.5%, with n=20. The sum of the discounted values (i.e. their Present Value) = \$696,330

The above calculations used two stages:

· Inflate the annual amount at 2% per year to produce the table of inflated future values.

· Discount at 6.5% the future values to the beginning of the series.
If all that is required is the discounted present value it is simpler to consider a series of 20 payments of 50,000 discounted at the difference (i - j) = 3.5%.

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End to date: 060321, ams