A dollar today is worth more than a dollar five years from now even if there is no inflation because today's dollar can be used productively in the ensuing five years, yielding a value greater than the initial dollar. Future benefits and costs are discounted to reflect this fact.
The purpose of discounting is to put all present and future costs and benefits in a common metric, their present value. Discounting is present in all benefit-cost Types of Measures.
Choice of a Discount Rate
The interest rates charged by banks include three components:
an inflation component to account for the decrease in purchasing power
a risk component, that is, a premium to account for the chance that the loan will not be repaid
a "real" interest rate to account for the productive value of the money.
Benefit-cost analyses typically ignore inflation because the prediction of future prices introduces unnecessary uncertainty into the analysis. Therefore, discount rates are typically based on interest rates for government borrowing, which has little risk, with the inflation component removed, yielding the "real" interest rate. This rate is typically calculated by subtracting the rate of inflation (consumer price index) from the interest rate of an investment such as a 10-year US Treasury bill. For example, if the interest on a 10-Year Treasury bill is 5.5 percent and the inflation rate is 3 percent, then the discount rate would be 2.5 percent.
The U.S. Office of Management and budget publishes "real" interests rates on its website http://www.whitehouse.gov/omb/circulars_a094_a94_appx-c/ Below are the real rates published on the site in December 2009.
Real Discount Rates. A forecast of real interest rates from which the inflation premium has been removed and based on the economic assumptions from the 2011 Budget are presented below. These real rates are to be used for discounting real (constant-dollar) flows, as is often required in cost-benefit analysis.
Real Interest Rates on Treasury Notes and Bonds of Specified Maturities (in percent)
3-year 5-year 7-year 10-year 20-year 30-year
0.9 1.6 1.9 2.2 2.7 2.7