Lesson 3: Inflation. Money ain t what it used to be

Transcription

1 Economagic Lesson 3: Inflation Money ain t what it used to be

2 Review In Lessons 1 and 2, we talked about the time value of money, which is represented by the interest rate We saw how interest compounds over time and how special formulas can be used to compute compound interest for a single dollar value or a payment series Future value formulas apply compounding to determine what money today is worth in the future Present value formulas apply discounting to determine what money in the future is worth today Now we will consider another important factor relating to money and time: Inflation

3 Learning Objectives 1. Understand the concept of inflation and its impacts 2. Understand the difference between nominal and real 3. Understand the concept of constant dollars 4. See how we can avoid the distortions of inflation when doing forestry financial analysis

4 Inflation Money today is worth more than in the future even exclusive of time preference Money s purchasing power diminishes over time because of inflation Prices increase over time $$ The value of money decreases Example: What does $1 buy today? What did it buy 10 or 20 years ago?

5 Inflation functions similar to an interest rate Example: 3% inflation (prices increase 3% per year on average) Consider a chain saw that costs $400 today To estimate how much it will cost in 5 years given inflation, we can use the future value formula ( ) 5 = $ 464 $ To estimate how much money it would have cost 5 years ago, we can use the present value formula $400 ( 1.03) 5 = $345

6 Measuring Inflation A well-known measure of inflation is the Consumer Price Index (CPI), computed by the Bureau of Labor Statistics The CPI tracks the price over time of a representative basket of goods and services for a typical consumer Online inflation calculator:

7 Nominal: Actual (Unadjusted) Values Nominal price: The actual price in the year it occurs Nominal price change: The actual change in price from year to year (including inflation) Nominal interest rate: The actual rate of interest on an account

8 Real: Adjusted for (net of) Inflation Real price: A price adjusted for inflation Real price change: A change in price net of inflation (i.e. a price change relative to other goods) Real interest rate rate of interest net of inflation Keep the right things together Nominal prices Nominal interest rates Real prices Real interest rates

9 Grocery Example Suppose that in 2006 you earn an income of $2/week. You go to spend your earnings at the grocery store and encounter the following prices: Milk: $0.50 Bread: $1.00 Eggs: $2.00 = = =

10 Grocery Example (cont.) Now suppose that in 10 years (2016) you earn $2.68/week but prices have also increased to the following: Milk: $0.67 Bread: $1.34 Eggs: $2.68 Nominal Change: Real Change: But has anything really changed? = = =

11 Grocery Example (cont.) But what if instead the grocery prices actually increased to the following: Nominal Change: Real Change: Milk: $0.89 Bread: $1.34 Eggs: $2.68 In this case there is a real (relative) change in the price of milk = = =

12 Constant Dollars When dealing with prices over time, we can keep everything in real terms (remove the distortion from inflation) by using constant dollars Rather than using nominal dollar values in their respective years, we relate everything to the purchasing power for a given base year

13 Grocery Example Revisited Item 2006 Price 2016 Price 2016 Price in 2006 Dollars Milk $0.50 $0.89 $0.67 Bread $1.00 $1.34 $1.00 Eggs $2.00 $2.68 $2.00

14 Forest Finance: Keeping it Real Keep prices in today s (constant) dollars Removes distortions of inflation Keeps everything relative to today s dollars (i.e. today s purchasing power) the easiest frame of reference Assumes no real changes over time The interest rate for forestry financial analysis would thus be a real interest rate Keep in mind that this is different from a nominal interest rate quoted at the bank

15 Forestry Example Revisited Recall from Lesson 1 our example of $300 to plant trees today that we expect to yield $8,000 in 40 years We compared this to investing the $300 in the bank at 10% interest and found that it would yield $13,578 a better deal However, our forestry example used today s (constant) timber values a 10% nominal interest rate is not a fair comparison!

16 Converting from a nominal to a real interest rate Over time money grows at the nominal interest rate but purchasing power is discounted by the inflation rate. Compound Interest (multiply by 1 + nominal interest rate i nom ) Inflation (divide by 1 + inflation rate f) The real (net) interest rate is the combination of these forces The Math: i real = ( 1+ i ) nom ( 1+ f ) 1 Note: You could simply subtract the inflation rate from the interest rate for a quick estimate, but more accurate results require division

17 Back to our Example The nominal interest rate at the bank is 10%. Assuming 3% inflation, what is the real rate of interest? Nominal interest rate (i nom ) =.10 Inflation rate (f) =.03 i real = ( 1+.10) ( 1+.03) 1 =.0680 = 6.80% Try it using the Economagic Calculator

18 New Solution Now that we have converted the nominal bank rate to a real interest rate, we can compare it to our constant dollar forestry example Using the future value formula, here is what the bank yields in the future in terms of today s dollars: $300 1 ( +.068) 40 = $4, 168 Our forestry yield of $8,000 is a better deal after all! This illustrates the importance of making equivalent comparisons relative to inflation

19 Converting from Real to Nominal We can also convert from real interest to nominal rates by multiplying Example: Suppose you could earn a 5% real rate of return by investing in forestry. If inflation is 3%, what nominal bank rate would be comparable? Real interest rate (i real ) =.05 Inflation rate (f) =.03 i nom = ( )( 1+.03) 1 =.0815 = 8.15% Try it using the Economagic Calculator

20 Concluding Thoughts Inflation is an important factor when dealing with money over time We can remove distortions from inflation by keeping forestry financial analysis in real terms (net of inflation) Constant prices Real interest rate When comparing forestry with other investment options, make sure it is an equivalent comparison (e.g. real vs. real)

21 References Consumer Price Index Home Page: Gunter, J.E. and H.L. Haney Essentials of Forestry Investment Analysis. Oregon State University Bookstores Inc., Corvallis, Oregon. 337 p. Klemperer, D.W Forest Resource Economics and Finance. McGraw Hill, New York. 551 p. Zobrist, K.W Economically Sustainable Working Forests: Financial Analysis Principles and Applications. Northwest Environmental Forum, College of Forest Resources, University of Washington, Seattle, WA. 16 p.

22 Economagic End of Lesson 3: Inflation Money ain t what it used to be