Inflation

Inflation is the increase in prices for goods and services over time. It implies a loss in the value of money over time, as it erodes the purchasing power of a currency.

Benefit-cost analysis for public sector projects generally controls for inflation, using estimates of future costs and benefits that are expressed in terms of today's (or some base year's) prices. These are referred to as "constant" or "real" dollars. Consistent with this approach, the discount rate used in benefit-cost analysis represents the time value of money after adjustment for inflation.

Example

A highway project is to be built in stages over a 10 year period. Costs and benefits projected for future years are presented in constant (non-inflated) dollars, either today's dollars or those of some other base year. There is no need to estimate how prices will increase over the ten years. The discount rate used to discount these costs and benefits to a present value is not the current market interest rate, which includes an inflation component, but rather the "real" discount rate, which excludes the effect of inflation.

Accounting for an Expected Relative Increase in Certain Benefits or Costs

Certain major cost or benefit items may be expected to experience future price changes much different than the normal rate of inflation. In such cases, a differential price factor may be applied to adjust these items for their different inflation rates. For example, if the future land cost is expected to increase over the project evaluation period at a rate 2% more than normal inflation, then future expenditures on land could be increased at 2% per annum.

However, adjustments for differential inflation are not often done in practical analyses, both because the future is uncertain and because such refinements are often seen as unlikely to influence the decision among the alternatives being considered.

Financial Analysis Taking Inflation Into Account

When cash flow and revenue streams are an issue, particularly in the private sector, costs and benefits are sometimes estimated in "nominal" (actual) dollars. This is not the typical benefit-cost analysis method, and on this website it is referred to as "financial analysis" In this case, specific price indices should be used which are appropriate for the inputs and outputs being considered. In the US, these may be found in the Survey of Current Business (published monthly by the Bureau of Labor Statistics, US Department of Labor). In such cases, the market interest rate for low risk investments should be used as the discount rate.

Example

A private electric utility evaluating a proposed major plant expansion compares future costs and revenues using several specific inflation rates applicable to the various resource inputs and energy outputs associated with the plant. In this case the market, or "nominal," interest rate would be used.

Warning: It is imperative that the discount rate be consistent with the treatment of inflation. If future costs and benefits follow the common practice of being expressed in terms of "real" ("constant") dollars, then discount rate should be the "real" interest rate. If future costs and benefits are expressed in terms of inflated ("nominal") dollars, then the discount rate to be used should be the "nominal" interest rate.

Sources

Grant, E. L., W. G. Ireson, and R. S. Leavenworth (1990), Principles of Engineering Economy, Eighth Edition, John Wiley & Sons (New York)

Lawrence Lindsey, Richard Schmalensee and Andrew Sacher (2011), The Effects of Inflation and Its Volatility on the Choice of Construction Alternatives, Concrete Sustainability Hub, Massachusetts Institute of Technology (http://web.mit.edu/cshub); at http://web.mit.edu/cshub/news/pdf/Inflation%20and%20Volatility.pdf.

C. S. Park (1997), Contemporary Engineering Economics, Second Edition, Addison-Wesley Publishing Company (Menlo Park, CA).