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INFLATION ADJUSTMENT

sumat singhal 
on 31 July 2008

LinkedIn


Inflation Adjustments
[Submitted by SUMAT SINGHAL
CA(PCC) INDORE]
It is a well known fact that inflation causes all the factors of the economy to change. Some of the important factors to get affected include investment, stocks, mortgage, unemployment, interest rates, exchange rates. Investments are made so that an investor gets more, from the amount that has been invested. People invest in bonds, stocks and adopt various other investment tools to channelize their money. Due to inflation, the value of money gets reduced over time. Consequently, the purchasing power of the individual also gets affected. Many investments are inflation protected and the process of rendering protection is referred to as inflation adjustment. Inflation adjustment protects the value of money invested.
 
Tools for measuring rate of inflation:
The important tools for measuring inflation are CPI or the consumer price index and the GDP or the gross domestic product.
When using any variables measured in terms of dollars such as income, earnings, sales, profit, GNP, care must be taken when interpreting changes in these variables over time. To avoid, or more accurately, to correct for the distortion caused by rising prices in a dollar denominated variable, economists construct a new variable known as the real, constant dollar, or inflation-adjusted variable.  In your economics courses you will most likely refer to the variables as real variables, while in any government data sources you will find references to constant dollar variables.
Regardless of what you call it, the concept is straight forward enough.  We want a measure of wages that will indicate no change in wages if both wages and prices double, and a doubling of wages if  wages double and the price level remains unchanged.  To construct such a measure we need to first decide on what measure of prices to use.  In most instances the Consumer Price Index (CPI) is used as a measure for the price level. The CPI, published monthly by the Bureau of Labor Statistics, is simply a weighted average of the prices of goods and services that households purchase.  If you tend to spend considerably more money on food than movies, you will see your cost of living decline more as a result of a 10 percent increase in the price of food than a 10 percent increase in the price of movies. 

Price Indexes
A Simple Example
The concept of a price index can be better seen with the aid of the simple example below. In this simple world we are concerned only with changes in the cost of entertainment. We begin by picking a base year, the year which we will use as the basis for our computations. For that year a survey is conducted in which we determine the types of entertainment that people participate in and their level of consumption. In this example, the base year is 1987, the year in which a survey revealed that the average household purchased four theater tickets, two concert and basketball tickets, five basketball tickets, went out to dinner eight times and escaped to a hotel twice.
ENTERTAINMENT PRICE INDEX
 
Price
 
Quantity
 
 
1987
1997
1987
1997
Theatre Ticket
10
25
4
3
Concert Ticket
3.5
10
2
1
Basketball Ticket
4
7
5
6
Football Ticket
5
10
2
3
Dinner
8
18
8
6
Hotel Room
30
75
2
2
ACTUAL 1987 EXPENSES = 10*4 +3.5*2 +4*5 +5*2 +8*8 +30*2 = 201
The level of expenditures on the entertainment basket in 1987 was Rs201. But what happens to the level of expenditures on entertainment by 1997? The expenditures on entertainment in 1997 are Rs415. The problem is that the difference [Rs415-Rs201] can be attributed to changes in the prices [the price of dinner rose from Rs8 to Rs18] and the entertainment mix changed [in 1997 we went to dinner 6 times instead of 8 times].
ACTUAL 1997 EXPENSES = 25*3 +10*1 +7*6 +10*3 +18*6 +75*2=415
To isolate the price changes we can calculate the value of our 1987 entertainment mix at 1997 prices.
HYPOTHETICAL 1997 EXPENSES ( 1987 PURCHASES/ 1997 PRICES )
= 25*4 +10*2 +7*5+ 10*2+ 18*8+ 75*2 = 469
With the hypothetical expenses in 1997 we can now create an index of prices in 1997, what we will call an Entertainment Price Index (EPI). The index is the ratio of the hypothetical to the base year expenditures multiplied by 100. In this example the EPI in 1997 is 233
EPI = 100*(469/201) = 233
Once we have the EPI, we can then make some statements about price level changes. With an EPI of 233, we can say the following:
(1) WHAT COST Rs100 IN 1987 COST Rs233 IN 1993
(2) PRICES MORE THAN DOUBLED
(3) PRICES WENT UP 133% (233-100)
(4) A 1987 DOLLAR IS WORTH Rs.43 (100/233)
And what about inflation?
Once you have the price index, inflation is easy. The inflation rate is simply defined as the percentage change in the price index. This rate is either specified as a monthly rate or as an annual rate. In the simple example above, if the EPI was 210 at the end of 1995 and 233 at the end of 1996, then the inflation rate for 1996 would be:
(233-201)/201 = 32/201 = .1592 = 15.92%
R = N/PI *100
R= real value (constant dollar)
N = nominal value (current dollar)
PI = price index
To incorporate into the analysis any effect of price inflation, we must start with getting information on the price level. In the third column  information on the price level has been added. 
 
Revenue
Price Index
1991
100
136.0
1992
90
140.3
1993
92
144.5
1994
95
148.2
1995
98
152.4
1996
101
156.95
With these data, and using the formula above, we can create a new concept called 'inflation adjusted', or Real Revenues. The 'real' data appear in the last column in the table below. What we see is that during this time Real Revenue actually declined by nearly 13 percent (64.30 - 73.53)/73.53.  The problem is , the real revenue figures are not numbers that are easy to explain.  This difficulty can be traced to the fact the price index has a base year (when the price index is 100) outside of the sample range so all of the numbers are specified in terms of that year.   What you can say based on these numbers is real wages have fallen 13 percent, you just can't say much about the actual numbers.
 
Revenue
Price Index
Real Revenue
1991
100
136
73.53
1992
90
140.3
64.15
1993
92
144.5
63.67
1994
95
148.2
64.10
1995
98
152.4
64.30
1996
101
156.95
64.35
This problem can be remedied if we convert all of the numbers based on one of the years in the sample.  Two obvious choices would be the beginning or the ending period. My suggestion would be to express the numbers in terms of the year closest to the one that you are in.  In this case, your analysis would be best if you expressed things in terms of 1996.  To obtain these numbers all that you need to do is modify the formula specified above.  The formula to get a column of real data in 1996 prices would be:
R(96) = [N/PI]*PI(96)
The term in brackets [N/PI] is the original measure of real wages and this is multiplied by the price index in 1999 PI(96).  You need to use the formula for real and then multiply the entire column by the price level in 1996 [PI(96)].  You know you have done it correctly if the nominal and real values for 1996 are the same.  The results appear in the table below.
 
Revenue
Price Index
Real Revenue
1991
100
136.0
115.4
1992
90
140.3
100.7
1993
92
144.5
99.9
1994
95
148.2
100.6
1995
98
152.4
100.9
1996
101
156.95
101.0
What we see here is real revenue in 1996 was virtually unchanged from what it had been in 1992, and substantially lower than 1991.  In fact you will see the decline in real revenue is the same when measure in terms of percent [(101-115.4)/115.4 = (64.30 - 73.53)/73.53].  The difference is that the 1996 numbers are easier to explain.  In 1996 revenue at the university was 101, down approximately 13 percent from 115.4 in 1991.
Inflation adjustment can be best understood by the following example:

For instance, a bond is bought for RS500 for a period of two years. During this period, inflation sets in and the price of the bond becomes RS600. It means, the bond, which was bought for RS500 can now be bought for RS600. This indicates that the value of money has declined. So, the profit, which the investor was entitled to avail after the maturity of the bond becomes insignificant. In order to protect the value of money from going down, inflation adjustment is relied on.
There can be inflation adjustment for many types of investments. Inflation adjustment can be for adjustments in oil prices, wages, price of gas, return (real return), annuity, bonds.
Inflation adjusted annuity
Inflation adjusted annuity is becoming more and more popular among people as it protects investors from losing their purchasing power.
An inflation adjusted annuity resembles an immediate annuity.
James and Vittas, two eminent economists say that, one has to pay a price for availing protection from inflation. This price differs from country to country and each country may have their own set of rules.

Inflation adjusted annuity requires one to pay less initially. Thereafter, due to inflation, the value is compounded and increases every year. Alternatively, some opt for annuities, whose payments increases gradually ranging between 1 percent to 5 percent.

The pricing of the inflation adjusted annuity is required to be competitive as compared to the regular annuities. However, the inflation adjusted annuity is capable of nullifying effects of inflation, which makes it more appealing to the common man.
Inflation adjusted Bond
Inflation not only affects the price level, it has an overall impact on all spheres of the economy. Stocks, bonds, investments are equally affected. Bonds are important tools, which safeguard individuals at the time of inflation. Bonds are safe to invest in, although the returns are less when compared to stocks.
Stagflation:
Whenever there is slowing down of the economy, interest rates drop. This impacts bonds because with decline in the interest rates, the price of bonds increases. Inflation adjusted bonds are those, which adjust the value of the bonds as per the rate of inflation, so that the value of the bonds do not subside. Although investing in bonds is safe but a condition, which is characterized by slow economy and increase in rate of inflation may hamper bonds.
Inflation adjusted Return
There are many ways by which investments can be saved from the ill effects of inflation. Classical example is furnished by the United States Treasury, offering various inflation protected securities. Inflation adjusted return is the real return of an investment, after removal of the effects of inflation. Owing to inflation, the purchasing power of money declines. In that case, the inflation adjusted return should be such, that even though inflation diminishes the purchasing power of money in no way affects the real return of investment. By doing so, the value of money remains at least stable and does not wither away with time.
 
Negating the ill effects of inflation:
If the ill effects of inflation are negated from an investment, the actual return (on investment) can be realized. If a bond held by an investor is 5% for a period of one year and if the rate of inflation for the same period was 8%, the real return is -3%. Hence investment ought to be calculated accordingly, so that the real return or inflation adjusted return is not negative.
 
Inflation Adjusted Wages
Inflation, as indicated by the CPI or the consumer price index, is the main reason, why economies around the world have to re orient themselves to adjust to the rate of inflation in an optimum manner. Inflation impacts various segments of the economy. It also affects wages. Due to the following three factors, a sharp decline in the real wages has been observed in the labor market. There is a close relationship between inflation and wages. Inflation adjusted wages are the wages, which do not lose value even when there is inflation. It is a well known fact that with inflation, value of money decreases. But, in case of inflation adjusted wages, this does not happen. Inflation adjusted wages also known as middle class squeeze, has declined sharply in recent years.
 
Inflation Adjusted Oil Prices
It is a well accepted fact that inflation extends its tentacles in all spheres of the economy Owing to inflation adjusted oil prices, a common man is paying much less as compared to what he had to shell out.
An overview of how inflation adjusted oil prices happened:
The period between 1946 through 1970, was when the nominal price of oil was fixed. But it was observed that inflation adjusted oil price dropped somewhat. This resulted because the oil prices were determined by OPEC or Organization of Petroleum Exporting Countries as well as Arab Oil Embargo. Before, OPEC and Arab Oil embargo took over, the United States government, had oil produced at a controlled price. The oil producers were instructed to do so. Hence, production of oil had subsided. As a result of thedecrease in production, more oil was brought into the country. If oil prices are intentionally held back, it boomerangs, causing massive distortions in the economy and in the oil sector, in particular. The price of oil remains in a floating state in an effort to revert back to the actual price of oil.
 
The price of gas has attained an all time high. However, some economists are of the opinion that, inflation adjusted gas prices are negligibly impacted by inflation due to inflation adjustment. Few say, that wages are a more serious cause of concern in comparison to oil as well as gas issues. It has been observed that gas prices are increasing gradually. After the Katrina hurricane struck, most of the refineries as well as pipelines were damaged.


As a result of this, availability of gas declined. This led to the increase in the prices of gases. Recently, it was recorded that in spite of having inflation adjusted gas prices, there was an increase in the cost of gases. Even though the price of gas has increased, it has not increased to the extent, when inflation adjusted gas prices reached the zenith. With the increasing number of passenger carriers, the demand for gas has escalated manifold. This has in turn given a boost to the revenues earned from the oil and gas sector (energy resources).
 
 



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