Inflation and the discount rate

Provision for inflationmay be made in two ways: (1) estimate all future costs and benefits in constant prices, and use a discount rate which represents the opportunity cost of capital in the ab-sence of inflation; or (2) estimate all future benefits and costs in current or inflated prices, and use a discount rate which includes an allowance for inflation. The discount rate in the first instance may be considered the real dis-count rate, while the discount rate in the second instance is the nominal discount rate. The use of current or inflated prices with the real discount rate, or constant prices with the nominal discount rate, will result in serious distor-tions in economic analysis.

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