Inflation was introduced previously as a term used to denote the phenomenon of price increase.  Since price increase is related with purchasing power of money, we can say that inflation accounts for changes in the purchasing power of money just as interest was said to account for the earning power of money.

In our treatment of equivalence calculations in previous chapters we focussed solely on the earning power of money.  We ignored the possibility of changes in the purchasing power.  We will no longer do so.  The effect of inflation will now be introduced in equivalence calculations.  We will see how inflation is integrated with interest and how we can work with an interest rate that represents the combined effects of price changes as well as earning power.

The market interest rate is a rate that represents the effects of price changes as well earning power changes.  The rate that accounts for the effect of changes in earning power only is denoted as the inflation-free interest rate, i', to distinguish it from the market interest rate, i, which represents the cumulative effects of earning power and inflation.  The inflation-free interest rate is also known as the real interest rate, since it is a measure of the true earning power of money.

When the cash flow is expressed in constant dollars, equivalence calculations can be done with the real interest rate, since the effect of inflation will have been removed from the cash flow.  Likewise with actual dollar cash flows, equivalence is calculated using the market interest rate, since the actual dollar cash flow will incorporate the effects of changes in earning power as well as price changes.  The critical thing to remember while computing equivalence in the presence of inflation is to work with only one type of cash flow, either constant or actual dollar cash flow.