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Inflation and the Time Value of Money

When a bank offers to pay 6 percent on a savings account, it promises to pay interest of $60 for every $1,000 you deposit. The bank fixes the number of dollars that it pays, but it doesn`t provide any assurance of how much those dollars will buy. If the value of your investment increases by 6 percent, while the prices of goods and services increase by 10 percent, you actually lose ground in terms of the goods you can buy.

REAL VERSUS NOMINAL CASH FLOWS

Prices of goods and services continually change. Textbooks may become more expensive (sorry) while computers become cheaper. An overall general rise in prices is known as inflation. If the inflation rate is 5 percent per year, then goods that cost $1.00 a year ago typically cost $1.05 this year. The increase in the general level of prices means that the purchasing power of money has eroded. If a dollar bill bought one loaf of bread last year, the same dollar this year buys only part of a loaf.

Economists track the general level of prices using several different price indexes. The best known of these is the consumer price index, or CPI. This measures the number of dollars that it takes to buy a specified basket of goods and services that is supposed to represent the typical family`s purchases.3 Thus the percentage increase in the CPI from one year to the next measures the rate of inflation.

Figure 1.15 graphs the CPI since 1947. We have set the index for the end of 1947 to 100, so the graph shows the price level in each year as a percentage of 1947 prices. For example, the index in 1948 was 103. This means that on average $103 in 1948 would have bought the same quantity of goods and services as $100 in 1947. The inflation rate between 1947 and 1948 was therefore 3 percent. By the end of 1998, the index was 699, meaning that 1998 prices were 6.99 times as high as 1947 prices.4 The purchasing power of money fell by a factor of 6.99 between 1947 and 1998. A dollar in 1998 would buy only 14 percent of the goods it could buy in 1947 (1/6.99 = .14). In this case, we would say that the real value of $1 declined by 100 Ј 14 = 86 percent from 1947 to 1998.

As we write this in the fall of 1999, all is quiet on the inflation front. In the United States inflation is running at little more than 2 percent a year and a few countries are even experiencing falling prices, or deflation.5 This has led some economists to argue that inflation is dead; others are less sure.

Economists sometimes talk about current or nominal dollars versus constant or real dollars. Current or nominal dollars refer to the actual number of dollars of the day; constant or real dollars refer to the amount of purchasing power.

Some expenditures are fixed in nominal terms, and therefore decline in real terms. Suppose you took out a 30-year house mortgage in 1988. The monthly payment was $800. It was still $800 in 1998, even though the CPI increased by a factor of 1.36 over those years.

What`s the monthly payment for 1998 expressed in real 1988 dollars? The answer is $800/1.36, or $588.24 per month. The real burden of paying the mortgage was much less in 1998 than in 1988.

INFLATION Rate at which prices as a whole are increasing.

REAL VALUE OF $1 Purchasing power-adjusted value of a dollar.

Talk Is Cheap

Suppose that in 1975 a telephone call to your Aunt Hilda in London cost $10, while the price to airmail a letter was $.50. By 1999 the price of the phone call had fallen to $3, while that of the airmail letter had risen to $1.00. What was the change in the real cost of communicating with your aunt?

In 1999 the consumer price index was 3.02 times its level in 1975. If the price of telephone calls had risen in line with inflation, they would have cost 3.02 $10 = $30.20 in 1999. That was the cost of a phone call measured in terms of 1999 dollars rather than 1975 dollars. Thus over the 24 years the real cost of an international phone call declined from $30.20 to $3, a fall of over 90 percent.

What about the cost of sending a letter? If the price of an airmail letter had kept pace with inflation, it would have been 3.02 $.50 = $1.51 in 1999. The actual price was only $1.00. So the real cost of letter writing also has declined.