Inflation is the increase in prices Inflation is the increase in prices over timeover time

Correspondingly, it represents Correspondingly, it represents the fall in the value of money the fall in the value of money over timeover time

The purchasing power of money The purchasing power of money gets reduced due to inflationgets reduced due to inflation

What is inflation?What is inflation?

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Inflation would affect different Inflation would affect different entities to a different extententities to a different extent

The affect would depend on the The affect would depend on the extent of price increase in their extent of price increase in their class of commonly used goodsclass of commonly used goods

Price change would not be in the Price change would not be in the same proportion for all goods in same proportion for all goods in a classa class

““Basket of goods” conceptBasket of goods” concept

How is inflation determinedHow is inflation determined??

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The value of Rs. 1,00,000 will become

Inflation (% p.a.)

No. of Yrs. 2 3 4 5 6

0 1,00,000 1,00,000 1,00,000 1,00,000 1,00,000

5 90,392 85,873 81,537 77,378 73,390

10 81,707 73,742 66,483 59,874 53,862

15 73,857 63,325 54,209 46,329 39,529

20 66,761 54,379 44,200 35,849 29,011

25 60,346 46,697 36,040 27,739 21,291

30 54,548 40,101 29,386 21,464 15,626

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List five different List five different goods/commodities utilised by goods/commodities utilised by A construction firmA construction firmAn urban householdAn urban household

Wholesale Price Index (WPI)Wholesale Price Index (WPI)Consumer Price Index (CPI)Consumer Price Index (CPI)

Inflation indexesInflation indexes

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Index of wholesale pricesIndex of wholesale pricesBasket of goods includeBasket of goods include

wholesale grainswholesale grainspowerpowercementcementsteel amongst otherssteel amongst others

Most commonly referred indexMost commonly referred index

Wholesale Price Index (WPI)Wholesale Price Index (WPI)

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Index of retail pricesIndex of retail pricesBasket of goods includeBasket of goods include

grains (retail price)grains (retail price)toothpastetoothpastesoap amongst otherssoap amongst others

Captures the increase in the ‘cost of Captures the increase in the ‘cost of living’living’

Consumer Price Index (CPI)Consumer Price Index (CPI)

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Items 1987 1997 2017

Colgate toothpaste 8.05 18.90 104.00

Masala Dosa 3.50 14.00 224.00

Petrol 7.90 25.48 259.12

Zodiac Shirt 225.00 510.00 2620.27

Cost of LivingCost of Living

The inflation (CPI) for the next year is The inflation (CPI) for the next year is expected to be 4%. A cake of lifebuoy expected to be 4%. A cake of lifebuoy is for INR 10 today. How many cakes is for INR 10 today. How many cakes can you buy after 1 year with INR10?can you buy after 1 year with INR10?

Price of one cake Price of one cake =10*(1+4/100)=10.4=10*(1+4/100)=10.4

No. of cakes = 10/10.4=0.962 No. of cakes = 10/10.4=0.962 Inflation has reduced the Inflation has reduced the Purchasing powerPurchasing power

ExerciseExercise

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Simply put, it is the price Simply put, it is the price of moneyof money

It is the compensation for It is the compensation for the opportunity cost of the opportunity cost of lending the moneylending the money

InterestInterest

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A rate of return is expected to A rate of return is expected to at least account for inflationat least account for inflation

Money would grow only when Money would grow only when returns above inflation are returns above inflation are availableavailable

Consequently, inflation also Consequently, inflation also has a bearing on the interest has a bearing on the interest ratesrates

Rate of returnRate of return

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Nominal rateNominal rate of return is the of return is the absolute return offered (e.g. absolute return offered (e.g. Infrastructure bond @9.32%)Infrastructure bond @9.32%)

All investment instruments are All investment instruments are quoted in terms of nominal ratequoted in terms of nominal rate

Real rateReal rate are return which have are return which have been adjusted to take inflation into been adjusted to take inflation into accountaccount

Real rate=Nominal rate-inflationReal rate=Nominal rate-inflation

Rate of returnRate of return

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Salaries at ABC Inc have grown by 4% Salaries at ABC Inc have grown by 4% this year. The relevant inflation index this year. The relevant inflation index is 4.3%. What is the real rate of is 4.3%. What is the real rate of increase?increase?

Real=Nominal - Inflation=4-4.3=-0.3%Real=Nominal - Inflation=4-4.3=-0.3%

Rate of returnRate of return

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Inflation robs away purchasing powerInflation robs away purchasing power@5% inflation, INR 105 one year hence @5% inflation, INR 105 one year hence

would be equal to INR 100 todaywould be equal to INR 100 todayHence, the timing of income/payment Hence, the timing of income/payment

streams assumes importancestreams assumes importancePresent Value(PV)= Future cash flow/ Present Value(PV)= Future cash flow/

appropriate discountappropriate discountIt tells us the worth of FCF todayIt tells us the worth of FCF today

Time Value of moneyTime Value of money

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