9.1 Measuring the Inflation Rate

Inflation = rate of increase in average prices of goods/services over time (usually annual).

Deflation = decrease in average prices → increases purchasing power.

Consumer Price Index (CPI)

• Measures the cost of a fixed “basket” of goods (food, shelter, transportation, etc.) relative to a base year.

  $$ f = \frac{\text{CPI}{n} - \text{CPI}{n-1}}{\text{CPI}_{n-1}} $$

• CPI helps convert between nominal and real values.

9.2 Economic Evaluation with Inflation

When evaluating projects:

• Current (Nominal) Dollars — reflect expected future price levels (include inflation).
• Real (Constant) Dollars — remove inflation effects, expressed in “base year” value (e.g., 2020 $).

Converting Current ↔ Real Dollars

• $C_N$ = current (nominal) value in year N
• $R_{0,N}$ = equivalent real value in base year 0
• $I_{0,N}$ = price index at year N relative to base year 0
• $f$ = inflation rate per year (constant)

Using CPI Index

$$ R_{0,N} = \frac{C_N}{I_{0,N} / 100} $$

Using Inflation Rate