Project evaluation during inflation

Abstract

Rules for correctly dealing with price and interest rate projections when one conducts benefit-cost analysis during inflation are derived. Recommendations of the Water Resources Council and those adopted in the Water Resources Development Act of 1974 are critiqued. The use of real prices and real opportunity cost interest rates is recommended as an improvement over the present practice of employing real prices and nominal financial interest rates.The current inflation in the United States, one of the most severe since the turn of the century, has stimulated a great deal of debate among academic, business, and government economists.. This debate has centered on the causes of this inflation, its consequences, and its cures. Our concern in this paper is not with these issues but rather with the proper approach to be used when benefit-cost analyses of water resource projects are to be pdrformed using data which reflect expected inflation.A survey of the benefit-cost literature reveals that the problems associated with project evaluation during inflation have been largely neglected or incorrectly handled. Such classics in the water resources field as Eckstein [1958] and Krutilla and Eckstein [1958] did not mention the problem. In most of the more well-known recent literature the analytical and practical issues surrounding evaluation for periods of inflation have remained conspicuously absent [see Harberger et al., 1972; Haveman et al., 1974; Little and Mirrlees, 1968; Mishan, 1971; Niskanen et al., 1973]. When inflation has been discussed, it has often been analyzed improperly [Hirshleifer et al., 1960; McKean, 1958; Posner, 1972; Stocktisch, 1969; Federal Register, 1973]. Howe's [1971] book in the water resources field and Hirshleifer's [1970] theoretical analysis of capital theory are particularly noteworthy as they correctly, although briefly, discuss the problems of evaluating projects during inflation.The purposes of this paper are to clarify the issues associated with evaluating projects when data which incorporate expectations of inflation are used and to present some recommendations for improving the evaluation of federal water projects. First, we present the principles for conducting evalua-Stocktisch, J. A., Measuring the 9pportunity cost of government investments, Res.

Economics of Timing Storm Drainage Improvements

“…Growth induced benefits and costs are properly included in the analysis only when calculated in constant money prices over time [Mishan, 1976]. Mixing nominal and real values in the same analysis will render the conclusions erroneous [Henke et al, 1975]. Therefore all values in (1) are discounted to their present value.…”

Forecasting Relative Price Movements for Project Evaluation

“…Denoting the general rate of inflation as I and the rate for some commodity price i as li, then the relative price inflation for price i is ri= 1 + Since nonzero values for ri can affect the outcome of a project evaluation, consideration must be given to their estimation in a planning study. It is generally agreed that values of r• should be estimated for major project impacts on limited resources such as wilderness areas [Hanke et al, 1975;Porter, 1982]. Of concern herein is whether they should also be estimated for less significant components of a project such as industrial product inputs and construction materials.…”

“…Benefitcost analysis is the standard procedure used in water resources studies to render varying costs and benefits spread through time into a set of commensurate values. Hanke et al [1975] show that there are two entirely equivalent approaches to the treatment of general inflation in benefit-cost analysis. The first uses inflating prices and a "nominal" discount rate based on interest rates that include the adjustment for inflationary expectations.…”

LUMP SUM TAX LOSS REIMBURSEMENT UNDER THE THAMES RIVER FLOOD CONTROL COMPACT1

“…The tax loss projection equations were developed from 1957 to 1978 data, a period during which the average annual inflation rate was between 3.5 and 4 percent, depending on what price index is evaluated. Therefore, an allowance for this amount of price inflation should have been included in the discount rates (see Hanke, et a,!, 1975, for a discussion of discounting during inflation). It seems likely that 1979-80 market interest rates which were established during a period of higher inflation included an expectation of at least 4 percent inflation even though interest rates seem to lag below inflation rates (Kopke, 1980).…”