CHAPTER 8

PRICE CHANGES AND

EXCHANGE RATES
DR. LEONARDO C. MEDINA, JR.
GENERAL PRICE INFLATION

An increase in the average price

paid for goods and services
bringing about a reduction in the
purchasing power of money.
GENERAL PRICE DEFLATION

A decrease in the average

price paid for goods in
services, resulting in an
increase in the purchasing
power of money.
 CONSUMER PRICE INDEX
(CPI)
• One measure of price changes in our
economy
• An estimate of general price inflation
• Tabulated by the Philippine Government
• A composite price index that measures
price changes in food, shelter, medical care,
transportation, apparel, and other selected
goods and services used by average
individuals and families
 CONSUMER PRICE INDEX
CPI is a La Speyres type index
CPIkk = (Qkk-1
-1 x Pkk) / (Qkk-1
-1 x Pkk-1
- 1)
•• Q -1 =
Qkk-1 = Preceding
Preceding year
year quantities
quantities
•• P
Pkk == Current -year prices
Current-year prices
•• P -1 =
Pkk-1 = Preceding
Preceding Year
Year Prices
Prices
CPI Annual Inflation Rate
= [ ((CPI
CPIkk - CPIkk-1
-1) / CPIkk-1
-1 ] x 100
•• CPI
CPIkk == Consumer
Consumer price
price index
index for
for the
the current
current year
year
•• CPI -1 =
CPIkk-1 = Consumer
Consumer price
price index
index for
for the
the preceding
preceding year
year
OTHER INFLATION INDICATORS
• While the CPI is shows how the prices that
consumers pay change from year to year or
month to month
• The PPI (Producer Price Index) shows how
the prices paid to producers change from
year to year or month to month
• The Implicit Price Deflator or GDP deflator
shows how all prices in the economy
change from one time period to another
time period
 INFLATION-RELATED TERMINOLOGY
INFLATION-RELATED
•• Actual
Actual pesos
pesos (AP)
(AP) -- (Current
(Current time
time frame)
frame) cash -flow
cash-flow
pesos : also
pesos also current
current pesos,
pesos, then -current pesos,
then-current pesos, or
or
inflated
inflated pesos
pesos
•• Real
Real pesos
pesos (RP)
(RP) -- Pesos
Pesos in
in terms
terms of
of purchasing
purchasing
power
power at
at some
some stated
stated time
time period
period (i.e.,
(i.e., base
base year):
year):
also
also constant
constant pesos
pesos
•• Base
Base period
period (b)
(b) -- Purchasing
Purchasing-power -power time time
reference
reference
•• General
General price
price inflation
inflation (( ff )) -- Measure
Measure of of change
change in
in
purchasing
purchasing power
power fromfrom one one time
time toto another
another
•• Combined
Combined (nominal)
(nominal) interestinterest rate
rate (( iicc)) -- Market
Market
interest
interest rate:
rate: actual
actual pesospesos paid paid for
for use
use of of capital
capital
•• Real
Real interest
interest rate
rate -- ((iirr)) -- Inflation -free interest
Inflation-free interest rate:
rate:
real
real pesos
pesos paid
paid for
for use
use of of capital
capital
RELATING ACTUAL PESOS TO REAL PESOS
•• Use
Use the
the following
following to
to convert
convert actual
actual pesos,
pesos, as
as of
of
time
time k,
k, to
to real
real pesos
pesos of
of constant
constant purchasing
purchasing
power
power
(RP)KK = (AP)KK [1/ (1+f)]KK-b
-b

= (AP)KK(P / F, f %, kk-b)
-b)
•• The
The equation
equation changes
changes asas follows
follows for
for aa specific
specific
type
type cash
cash flow
flow (i.e.
(i.e. specific
specific good
good or service ““jj ”” ))
or service
(RP)KK jj = (AP)KK jj [1/ (1+f)]KK-b
-b

= (AP)KK jj (P / F, f %, kk-b)
-b)
•• In
In the
the base
base period,
period, purchasing
purchasing power
power of
of actual
actual
peso
peso and
and real
real peso
peso are
are the
the same
same
RELATING
RELATING COMBINED
COMBINED AND
AND REAL
REAL INTEREST
INTEREST
RATES
RATES AND
AND GENERAL
GENERAL INFLATION
INFLATION RATE
RATE

i rr = ( i cc - f ) / ( 1 + f )
• Similarly, current -peso internal rate
current-peso
of return is related to the real rate of
return in the following way:
IRR rr = (IRR cc - f ) / ( 1 + f )
 FIXED AND RESPONSIVE
ANNUITIES
• Cash flows predetermined by
contract -- bonds or fixed annuities --
do not respond to general price
inflation
• Future amounts that are not
predetermined may, by varying
degrees, respond to general price
inflation
 CALCULATING AN EFFECTIVE GENERAL
PRICE INFLATION RATE

• f = An (estimated) effective general price

inflation rate for a period of N years

 11 // N
N
f=  kk=1
=1( 1 + f kk ) -1
 DIFFERENTIAL PRICE INFLATION
•• Variation
Variation between
between general
general price
price inflation
inflation rate
rate and
and
the
the best
best estimate
estimate of
of future
future price
price changes
changes for
for
specific
specific goods
goods and
and services
services
II
• e jj -- The
The increment
increment (( %
% )) of
of price
price change
change above
above
or
or below
below the
the general
general price
price inflation
inflation raterate for
for aa given
given
time
time period
period for
for good
good or service ““ jj ““
or service
•• Caused
Caused by:
by: changes
changes in
in supply,
supply, changes
changes in in
demand,
demand, technological
technological improvements,
improvements,
productivity
productivity changes,
changes, regulatory
regulatory requirements
requirements
 TOTAL PRICE ESCALATION
•• Price
Price changes
changes caused
caused byby some
some combination
combination of
of
general
general price
price and
and differential
differential price
price inflation
inflation
•• ee jj --
-- The
The total
total rate
rate (%)
(%) of
of price
price change
change during
during aa
time
time period
period for
for good
good or service ““ jj ““
or service
•• Includes
Includes the the effects
effects of of both
both the
the general
general price
price
inflation
inflation raterate (( ff )) and
and the
the differential
differential price
price inflation
inflation
II
rate (e
rate (e jj )) on
on price
price changes
changes
II
ee jj == (( ee jj -- ff )) // (( 11 ++ ff ))
(AP)
(AP) kk jj == (AP)
(AP) bb jj (F
(F // P,
P, ee jj %,
%, kk -- b
b ))
II
(AP)
(AP) bb jj == (AP)
(AP) bb jj (F
(F // P,
P, ee jj %,
%, kk -- b
b ))
DETERMINING A CONVENIENCE RATE
FOR GEOMETRIC CASH FLOW
SEQUENCES

• Actual peso analysis ( AP )

iCR
CR
= ( icc - e jj ) / ( 1 + e jj )
• Real peso analysis ( RP )
II II
iCR
CR
= ( irr - e jj ) / ( 1 + e jj )
 MARKET INTEREST RATE OF RETURN
RELATIVE TO PHILIPPINE PESOS
i ff cc = i Php
Php
+ f ee + f ee ( i Php
Php
)
i Php
Php
= ( i ff cc - f ee ) / ( 1 + f ee )
•• ii Php = market (combined ) interest rate of
Php = market (combined ) interest rate of
return
return relative
relative to
to Philippine
Philippine pesos
pesos
•• ii ff cc == market
market (combined
(combined )) interest
interest rate
rate of
of return
return
relative
relative to
to foreign
foreign country
country currency
currency
•• ffee == Annual
Annual rate
rate of
of change
change inin exchange
exchange rate
rate --
--
annual
annual devaluation
devaluation rate
rate --
-- between
between foreign
foreign
country
country currency
currency andand Philippine
Philippine peso
peso
–– ffee +:+: foreign
foreign currency
currency devalued
devalued relative
relative to
to peso
peso
–– ffee -- :: peso
peso devalued
devalued relative
relative to
to foreign
foreign currency
currency