---
title: "Inflation, effects, inflation-free rate"
subject: "Engineering Economics"
chapter: 8
key: "semester_6/engineering_economics:define-inflation-effects-implied-rate"
source: https://www.bctengineer.com/q/semester_6/engineering_economics/define-inflation-effects-implied-rate
site: BCT Engineering
---

# Inflation, effects, inflation-free rate

Engineering Economics · Chapter 8: Inflation and Its Impact on Project Cashflows

- Asked in: 2069 Bhadra, 1+1+2 marks
- Video: [Low stable inflation #2 - Consequences of inflation & deflation](https://www.youtube.com/watch?v=ZQ9L8vlt204) — Mohamed Elashiry - The IB Econ Guru
- Answer checked by Claude Opus 5.5 (high effort) on 2026-10-14
- Page: https://www.bctengineer.com/q/semester_6/engineering_economics/define-inflation-effects-implied-rate
- Whole chapter: https://www.bctengineer.com/md/semester_6/engineering_economics/chapter-8

## Question

Define inflation. List out its effects. If the inflation rate is 5% per year and the market interest rate is 13% per year, what is the implied interest (inflation free) rate in inflationary economy?

## Short answer

Inflation is a continuing rise in general prices, reducing money's purchasing power. Effects include falling real savings, higher interest rates, rising project costs, wealth transfer from lenders to borrowers, and harm to fixed-income groups. Implied inflation-free rate i' = (i - f)/(1+f) = (0.13-0.05)/1.05 = 7.62% per year.

## Answer

#### Inflation
Inflation is a continuing rise in the general level of prices of goods and services, so that a unit of money buys less over time.

#### Effects of inflation
- Purchasing power of money and the real value of savings fall.
- Interest rates rise, and the cost of borrowing and projects increases.
- Costs of materials, labour and equipment rise, so budgets are exceeded.
- Wealth is transferred from lenders to borrowers who repay in cheaper money.
- Fixed-income groups (pensioners, salaried people) are hurt; planning for long-lived projects becomes more uncertain.
- Revenues from fixed-price contracts lose real value.

#### Implied inflation-free rate
Market rate i = 13%, inflation f = 5%:
```text
i = i' + f + i'f   →   i' = (i − f)/(1 + f)
i' = (0.13 − 0.05)/(1 + 0.05) = 0.08/1.05 = 7.62%
```
**Answer:** The implied inflation-free interest rate is **7.62% per year**.

## Check yourself

The answer's key points as multiple-choice questions, with the correct option and why.

1. Which statement about inflation's effect is correct?
   A. Wealth shifts from borrowers to lenders
   B. Wealth shifts from lenders to borrowers repaying in cheaper money
   C. Fixed-income groups gain
   D. Interest rates fall
   Answer: B. Borrowers repay in money of lower purchasing power; fixed-income groups lose and interest rates tend to rise. (Key point: Effect on lenders and borrowers)

2. Which relation gives the implied inflation-free rate?
   A. i' = i + f
   B. i' = i - f
   C. i' = (i - f)/(1 + f)
   D. i' = i/f
   Answer: C. It comes from i = i' + f + i'f. (Key point: Formula)

3. With i = 13% and f = 5%, the implied inflation-free rate is
   A. 8%
   B. 7.62%
   C. 18%
   D. 8.4%
   Answer: B. 0.08/1.05 = 7.62% per year. (Key point: Result)

## Related in Engineering Economics

- [Short note: market vs inflation-free interest rate](https://www.bctengineer.com/question.md?key=semester_6%2Fengineering_economics%3Ashort-note-market-vs-inflation-free) — Engineering Economics, chapter 8
- [Constant vs actual dollar; inflation-free rate on loan](https://www.bctengineer.com/question.md?key=semester_6%2Fengineering_economics%3Aconstant-actual-dollar-bike-loan) — Engineering Economics, chapter 8, asked 2×
- [Car loan interest rate and lump sum at year 3](https://www.bctengineer.com/question.md?key=semester_6%2Fengineering_economics%3Acar-loan-installments-lump-sum-year3) — Engineering Economics, chapter 2