REAL VALUES AND MONEY OF THE DAY VALUES
Points to make
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If there is inflation over a number of years, then the amount of goods or services that can be bought for $1 is less each year. If there is 10 per cent inflation, a kilogramme of sugar which cost $10 last year will cost $11 this year. The value of the dollar shrinks in- a period of inflation.
If I want to build a house, I get an estimate from a contractor. The contractor might tell me that the house will cost $300,000 to build. If I
I need to borrow the $300,000, I would be unwise to go to the bank to ask for a $300,000 loan (unless I am sure there will be no inflation in the next two years) because I know that the $300,000 I borrow will be worth less by the time the house has been built and I have to make the final payment. Then I would have to ask the bank for more.
Suppose the
contractor tells me it will take three years to build the house, and each year, one third of the work would be completed, then I shall have to pay $100,000 in each year. But if inflation is expected to be 10 per cent, in the second year I shall need $110,000 to pay for the second portion of the works. By the third year, cumulative inflation since the start will be 21 per cent, so I shall need $121,000 to pay for the final third. $100,000 plus $110,000 plus $121,000 is $331,000. That is the sum I need to borrow.
This
calculation takes me from the real dollar prices (in 1992 constant dollars) to the money-of-the-day price. There has been no cost overrun: the dollar has shrunk.
Money of the Day: p.1 of 2
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