Use of Consistent Prices, Exchange Rates and Interest Rates in Project Evaluation

Question 1

Price Level

Answer 1

P t,L = Sigma Pt,i*Wi
Where
i= 𝑖𝑛𝑑𝑖𝑣𝑖𝑑𝑢𝑎𝑙 𝑔𝑜𝑜𝑑 𝑜𝑟 𝑠𝑒𝑟𝑣𝑖𝑐𝑒 𝑖𝑛𝑐𝑙𝑢𝑑𝑒𝑑 𝑖𝑛 𝑡ℎ𝑒 𝑚𝑎𝑟𝑘𝑒𝑡 𝑏𝑎𝑠𝑘𝑒𝑡
Pt,i= 𝑝𝑟𝑖𝑐𝑒 𝑜𝑓 𝑡ℎ𝑒 𝑔𝑜𝑜𝑑 𝑜𝑟 𝑠𝑒𝑟𝑣𝑖𝑐𝑒 𝑎𝑡 𝑎 𝑝𝑜𝑖𝑛𝑡 𝑖𝑛 𝑡𝑖𝑚𝑒
Wi= 𝑡ℎ𝑒 𝑤𝑒𝑖𝑔ℎ𝑡 𝑔𝑖𝑣𝑒𝑛 𝑡𝑜 𝑡ℎ𝑒 𝑝𝑟𝑖𝑐𝑒 𝑜𝑓 𝑎 𝑝𝑎𝑟𝑡𝑖𝑐𝑢𝑙𝑎𝑟 𝑔𝑜𝑜𝑑 𝑜𝑟 𝑠𝑒𝑟𝑣𝑖𝑐𝑒 and the sigma Wi equal to 1

Question 2

it is generally useful to express the price level of a basket of goods and services at a specific point in time in terms of a price index

Answer 2

Pt,I= Pt,L/PB,L
Pt, L= 𝑡ℎ𝑒 𝑝𝑟𝑖𝑐𝑒 𝑙𝑒𝑣𝑒𝑙 𝑖𝑛 𝑝𝑒𝑟𝑖𝑜𝑑 𝑡.
PB, L= 𝑡ℎ𝑒 𝑝𝑟𝑖𝑐𝑒 𝑙𝑒𝑣𝑒𝑙 𝑓𝑜𝑟 𝑡ℎ𝑒 𝑏𝑎𝑠𝑒 𝑝𝑒𝑟𝑖𝑜𝑑

Question 3

Inflation is measured in terms of a price index:

Changes in Price Level (Inflation)

Answer 3

gPe, I= (P t, I - P t-1, I) / P t-1, I * 100

Question 4

Real Prices

Answer 4

P_t, ir= P_t, i/ P_t, I
where 𝑃_t^i=𝑛𝑜𝑚𝑖𝑛𝑎𝑙 𝑝𝑟𝑖𝑐𝑒 𝑜𝑓 𝑔𝑜𝑜𝑑 𝑜𝑟 𝑠𝑒𝑟𝑣𝑖𝑐𝑒 (𝑖) 𝑎𝑠 𝑜𝑓 𝑎 𝑝𝑜𝑖𝑛𝑡 𝑖𝑛 𝑡𝑖𝑚𝑒 (𝑡)
𝑃 _𝐼^𝑡=𝑝𝑟𝑖𝑐𝑒 𝑙𝑒𝑣𝑒𝑙 𝑖𝑛𝑑𝑒𝑥 𝑎𝑡 𝑡𝑖𝑚𝑒 𝑝𝑒𝑟𝑖𝑜𝑑 (𝑡)

Question 5

Changes in Real Prices

Answer 5

𝑃_𝑡 ^ 𝑖𝑅− 𝑃 (𝑡−1) ^ 𝑖𝑅 / 𝑃(𝑡−1) ^ 𝑖𝑅

where 𝑃_𝑡^𝑖𝑅=real price of good (i) as of a specific period

Question 6

Change in the price level

Answer 6

measured by price index

Question 7

Inflation-Adjusted Values

Answer 7

It is the inflation-adjusted values that are used in the estimation of the nominal cash flows of a project

Question 8

Inflation-Adjusted Values

Formula

Answer 8

𝑃̂(𝑡+1)^𝑖=𝑃_𝑖^𝑡 (1+𝑔𝑃(𝑡+1^𝑖𝑅))(1+𝑔𝑃_(𝑡+1)^𝐼)
where 𝑃̂(𝑡+1)^𝑖=𝑡ℎ𝑒 𝑒𝑠𝑡𝑖𝑚𝑎𝑡𝑒𝑑 𝑛𝑜𝑚𝑖𝑛𝑎𝑙 𝑝𝑟𝑖𝑐𝑒 𝑜𝑓 𝑔𝑜𝑜𝑑 (𝑖)𝑖𝑛 𝑦𝑒𝑎𝑟 𝑡+1
𝑃_𝑡^𝑖=𝑡ℎ𝑒 𝑟𝑒𝑎𝑙 𝑝𝑟𝑖𝑐𝑒 𝑜𝑓 𝑔𝑜𝑜𝑑 (𝑖) 𝑖𝑛 𝑦𝑒𝑎𝑟 𝑡
𝑔𝑃(𝑡+1)^𝑖𝑅=𝑡ℎ𝑒 𝑒𝑠𝑡𝑖𝑚𝑎𝑡𝑒𝑑 𝑔𝑟𝑜𝑤𝑡ℎ 𝑖𝑛 𝑟𝑒𝑎𝑙 𝑝𝑟𝑖𝑐𝑒 𝑜𝑓 𝑔𝑜𝑜𝑑 (𝑖)𝑏𝑒𝑡𝑤𝑒𝑒𝑛 𝑦𝑒𝑎𝑟 𝑡 𝑎𝑛𝑑 𝑡+1
𝑔𝑃_(𝑡+1)^𝐼=𝑡ℎ𝑒 𝑎𝑠𝑠𝑢𝑚𝑒𝑑 𝑔𝑟𝑜𝑤𝑡ℎ 𝑖𝑛 𝑝𝑟𝑖𝑐𝑒 𝑙𝑒𝑣𝑒𝑙 𝑖𝑛𝑑𝑒𝑥 𝑓𝑟𝑜𝑚 𝑦𝑒𝑎𝑟 𝑡 𝑡𝑜 𝑡+1

Question 9

Constant Prices

Answer 9

Fixed set of prices at a given year 𝑡_0

Question 10

Fixed set of prices at a given year 𝑡_0

Answer 10

𝑃_(𝑡+𝑛)^𝑖=𝑃_(𝑡0 )^𝑖 ; 𝑃_(𝑡+𝑛)^𝑘=𝑃_(𝑡0 )^𝑘

Question 11

It is not a useful concept to use in project evaluation.

Answer 11

While nominal prices are affected by changes in real prices as well as changes in the price level, constant prices reflect neither of these economic forces

Question 12

Expected Nominal Exchange Rate

Answer 12

The market exchange rate is the current price of foreign exchange

Question 13

The market rate between the domestic currency and foreign currency can be expressed at a point in time (t) as:

Answer 13

𝐸_𝑀^𝑡=〖(#𝐷/𝐹)〗_𝑡

Question 14

If the price index for the domestic currency’s economy is 𝐼_𝐷^𝑡 at time t, and the price index for the foreign currency’s country is 𝐼_𝐹^𝑡, then the real exchange rate 𝐸_𝑅^𝑡 at that point in time can be expressed as:

Answer 14

1. 𝐸_𝑅^𝑡= (#𝐷/𝐹)_𝑡∗(𝐼_𝐹^𝑡/ 𝐼_𝐷^𝑡)
2. 𝐸_𝑅^𝑡=𝐸_𝑀^𝑡∗(𝐼_𝐹^𝑡/ 𝐼_𝐷^𝑡 )
3. 𝐸_𝑀^𝑡=𝐸_𝑅^𝑡∗(𝐼_𝐷^𝑡/ 𝐼_𝐹^𝑡)

Question 15

As conducting a financial appraisal of a project, we select the first year of the project, 𝑡_0 as the base year for the calculation of the relative price indices.

Answer 15

Using 𝑡_0 as the base year, the values for both 𝐼_(𝑡_0)^𝐷 and 𝐼_(𝑡_0)^𝐹 will be equal to 1.

Question 16

Market exchange rate, 𝐸_𝑡^𝑀 and real exchange rate, 𝐸_𝑡^𝑅 will be

Answer 16

equal to each other in the base period.

Question 17

If the domestic economy faces a rate of inflation different from that of a foreign trading partner,

Answer 17

there will be difference between the real and nominal exchange rates over time even though the real exchange rate remains same.

Question 18

Benchmark Assumption for Exchange Rate Behavior

Answer 18

Purchasing power parity will tend to hold if averaged over the life of a project. The amount of cumulated relative inflation (cumulated domestic over cumulated foreign inflation) will be approximately equal to the adjustment of the nominal exchange rate over time.

There will be major deviations from this in shorter time periods.

Empirical evidence supports this assumption.

Question 19

We can derive the market exchange rate in period (t+n), 𝐸_(𝑡+𝑛)^𝑀, that is required given that the projected real exchange rate as in period (t+n) is 𝐸_(𝑡+𝑛)^𝑅, and given the movement in the price levels of the two countries between period (t) and (t+n). It is expressed as:

Answer 19

E M, t+n= E R, t+n * I D, t+n/ I F, t+n

Question 20

Since the integrated project analysis begins with the

Answer 20

financial analysis and then the economic analysis

Question 21

While a project profile is given by cash flows in

the financial appraisal, the project’s profile in the economic appraisal provides a

Answer 21

the flow of net economic benefits generated by the investment.

Question 22

From a country’s prospective, a project should be undertaken if it generates a

Answer 22

positive net economic benefit.