Inflation
Inflation is an economic term that indicates the increase in price of goods and services over time and can be more precisely defined as “a persistent rise in the prices associated with a basket of goods and services that is not offset by increased productivity.” Inflation causes purchasing power to reduce (more information can be found at Inflation (Investopedia) and at Inflation (Wikipedia). Inflation affects almost everything in the financial market and it is measured and reported by various indexes. The most common index for determining the inflation rate is called the Consumer Price Index or CPI. You can read more about the CPI at the Wikipedia page for Consumer Price Index. Monthly CPI reports are published at the U.S. Bureau of Labor Statistics website.
Escalation
"Escalation refers to a persistent rise in the price of specific commodities, goods, or services due to a combination of inflation, supply/demand, and other effects such as environmental and engineering changes." Factors that affect the escalation include:
 Inflation
 Supply/demand
 Technological Changes
 Environmental Effects
 Political Effects
 Miscellaneous Effects
As defined above, inflation refers to the increased price of a basket of goods and services, while escalation refers to an increase in price of a specified good or service. Inflation is one of the factors that cause escalation. The Alaskan pipeline is a good example that can help with understanding the difference between inflation and escalation. This pipeline was estimated to cost about 900 million dollars in 1969, while the final estimate in 1977 came to about 8 billion dollars for the project, which is around 900% higher than the initial estimation. You should note that just a portion of this increase was due to the inflation rate and that other factors such as supply/demand effects on labor and materials, and environmental and technology changes also contributed to the substantial increase in costs.
There are two techniques used to take into account the effect of inflation and escalation in economic analysis. Both methods should lead into the same results:
1. Escalated dollar analysis
"Escalated dollar values refer to actual dollars of revenue or cost that will be realized or incurred at a specific future point in time."
2. Constant dollar analysis
"Constant dollar values refer to hypothetical constant purchasing power dollars obtained by discounting escalated dollar values at the inflation rate to some arbitrary point in time, which often is the time that corresponds to the beginning of a project. Constant dollars are referred to as real dollars or deflated dollars in many places in the literature."
Escalated dollar analysis considers different purchasing power for different points in time, while constant dollar analysis aims to set a same base and a constant purchasing power for all points in time. Constant dollar analysis requires more calculation and the chance of making mistakes increases, while escalated dollar analysis has more reliable results. Escalated dollar and constant dollar analysis are two different methods and their results shouldn’t be compared. A common mistake in applying the results of constant dollar analysis is to compare the calculated constant dollar ROR with other escalated dollars investment opportunities such as bank interest rate and so on. Therefore, constant dollar ROR for alternative investment opportunities (constant dollar minimum rate of return) should be the base for comparing and evaluating constant dollar analysis for an investment project.
Usually reported cost, revenue, and incomes occurring in different points of time are reported at today’s dollar. Escalated dollar approach applies an assumed escalation rate to predict and increase the sums over time. To do so, similar to compounding technique, a single payment compound amount factor (F/P_{i,n}) has to be multiplied by the amount, and escalation rate has to be substituted for i.
For example, consider an investment with the following cashflow:
C_{0}=$10,000  C_{1}=$10,000  I_{2}=$15,000  I_{3}=$15,000 


0  1  2  3 
C: Capital Cost, I: Income
Assuming an escalation rate of 12%, escalated dollar cashflow is:
C_{0}=$10,000  C_{1}=$10,000*(F/P_{12%,1}) =$11,200 
I_{2}=$15,000*(F/P_{12%,2}) =$18,816 
I_{3}=$15,000*(F/P_{12%,3}) =$21,074 


0  1  2  3 
Please watch the following video (6:25) Inflation, escalation, and escalated dollar analysis.
Escalation rate includes the inflation rate, and constant dollar approach applies a constant purchasing power by removing the effect of inflation rate from escalated dollars. Inflation effect can be removed, similar to discounting technique, by multiplying the single payment present worth factor (P/F_{i,n}) by escalated dollars and applying inflation rate as i. Many investors choose to utilize the anticipated inflation over future years as an approximation for escalation. Commodity prices, the price for construction equipment, steel, concrete, labor, and energy, may not move in direct correlation with the rate of inflation. Note that negative escalation rate can also be applied, if decrease in costs, revenue, or income is anticipated.
For example, considering inflation rate of 6% for above escalated dollar cashflow, constant dollar cashflow can be calculated as:
C_{0}=$10,000  C_{1}=$11,200*(P/F_{6%,1}) =$10,566.04 
I_{2}=$18,816*(P/F_{6%,2}) =$16,746.17 
I_{3}=$21,074*(P/F_{6%,3}) =$17,694.07 


0  1  2  3 
Please watch the following video (4:11): Constant dollar analysis.
Last but not least, gold has been considered a good hedge against the longterm impact of inflation. Back in 1990, the gold price was $420 per ounce. In the mid 2000s, the price had fallen to $270 per ounce. That means an annual price decline of 4.1% per year over 10 years. During the same period, US inflation (as measured by CPI) averaged approximately 3% per year. If gold price would have increased in value at the rate of inflation, the value in 2000 would have been:
$$420*\left(F/{P}_{3\%,10}\right)=420*1.3439=\$564/\text{ounce}$$Instead, the actual price dropped to $275 per ounce and the corresponding constant dollar equivalent price of gold dropped to
$$275*\left(P/{F}_{3\%,10}\right)=275*0.7441=\$205/\text{ounce}$$In 2008, the gold trading price was $925 per ounce, an investment in an ounce of gold in 1990 would have produced an average annual rate of return of
$$\begin{array}{l}0=420+925*\left(P/{F}_{i,18}\right)\\ i=ROR=4.48\%\end{array}$$After adjusting for an assumed 3% per year inflation, the real return on your investment would be closer to 1.4% per year. The calculations related to this type of constant dollar measure of economic performance will be developed in the Example 51 on the next page.
Practice Example:
Currently (May 2020) gold is trading at around $1,700 per ounce. How much would be the average annual rate of return of an investment in one ounce of gold in 1990? How much would be the rate of return, adjusted for inflation, assuming 3% per year of inflation in average?
Answer: 4.77% and 1.7% (approx.)
Italicized sections are from Stermole, F.J., Stermole, J.M. (2014) Economic Evaluation and Investment Decision Methods, 14th edition. Lakewood, Colorado: Investment Evaluations Co.