Inflation Adjusted Decisions
INFLATION ADJUSTED DECISIONS
Definition:
Inflation is a quantitative measure of the rate at which the average price
level of a basket of selected goods and services in an economy increases over a
period of time. It is the constant rise in the general level of prices where a
unit of currency buys less than it did in prior periods. Often expressed as a
percentage, inflation indicates a decrease in the purchasing power of a
nation’s currency.
Inflation is the rate of increase in the prices of goods per period. So, it has a compounding effect. Thus, prices that are inflated at a rate of 7% per year will increase 7% in the first year, and for the next year the expected increase will be 7% of these new prices.
Inflation is the rate of increase in the prices of goods per period. So, it has a compounding effect. Thus, prices that are inflated at a rate of 7% per year will increase 7% in the first year, and for the next year the expected increase will be 7% of these new prices.
If
economic decisions are taken without considering the effect of inflation into account,
most of them would become meaningless and as a result the organizations would
end up with unpredictable return.
PROCEDURE TO ADJUST INFLATION
A
procedure to deal with this situation is summarized now.
1.
Estimate all the costs/returns associated with an investment proposal in terms
of today’s rupees.
2.
Modify the costs/returns estimated in step 1 using an assumed inflation rate so
that at each future date they represent the costs/returns at that date in terms
of the rupees that must be expended/received at that time, respectively.
3.
As per our requirement, calculate either the annual equivalent amount or future
amount or present amount of the cash flow resulting from step 2 by considering
the time value of money.
TYPES OF INFLATION
Creeping
inflation
Creeping
or mild inflation is when prices rise 3% a year or less. This is slow moving
and not predictable. In general, when prices increase 2% or less it benefits
economic growth. This kind of mild inflation makes consumers expect that prices
will keep going up. That boosts demand. Consumers buy now to beat higher future
prices.
Moderate
inflation
Moderate
inflation is in moderate speed (i.e) between 3-10% a year. It is harmful to the
economy because it makes economic growth too fast. People start to buy more
than they need, just to avoid tomorrow's much higher prices. This drives demand
even further. As a result, common goods and services are priced out of the
reach of most people.
Galloping inflation
When
inflation rises to 10% or more, it affects the economy on a large scale. Due to
this inflation money loses its value so fast that business and employee income
can't keep up with costs and prices. Foreign investors avoid the country, because
the country Loses the necessary capital. The economy becomes unstable, and
government leaders lose credibility. Galloping inflation must be prevented at
all costs.
Hyper-inflation
Hyperinflation
is when the prices of goods and services rise more than 50% a month. It is an extremely rapid period of inflation,
usually caused by a rapid increase in the money supply. Hyperinflation
usually involves prices changing so fast, that it becomes a daily occurrence,
and under hyperinflation, the value of money will rapidly decline.
