Updated on: June 10, 2020 ; Wealth & Value
What is the value of money?
I have already talked about value at length. Click on this link to read that article, in case you have not read it already. Today we will focus on the time value of money and how it changes with time.
The value of money can be determined by the number of goods or services money can buy. This is also known as the purchasing power of money. Let’s look at an example to elaborate on this.
Imagine 1000 units of money can buy you 10 gms of silver today. So 1 unit of money is worth 0.01 gms of silver. This is the value of money in terms of silver.
Introduction to Inflation
Coming back to the silver example, a year later, the same 10 gms of silver costs 1500 units of money. What just happened here? We can say that the value of money decreased here. It depreciated by 33.33%. Try to find out how did I get 33.33%.
In the real world, unless you deal with silver, the daily valuation of money in terms of silver should not be a concern. You would be more concerned with the price of goods and services that you consume regularly.
Now, this basket of your regular consumption would comprise of a lot of things. It will be a daunting task for you to track the exact price movement of this basket over the last few years. But if you try to think of the price movement of the key items in this basket, what would be your observation?
You will notice an increase in the price of most of the things you consume. The rate of change will vary, but the direction would be up for most of them. This upward movement of prices is called inflation. Different governments have their own ways to calculate inflation. There could be many different categories of inflation as well. We don’t need to go into the details of it now.
What does it mean for you?
Now, that the concepts of the time value of money and inflation are clear to you, what does it mean for you?
If you were to go by the trends in most of the stable economies, you would notice healthy inflation over long periods. The value will differ by years, but the direction would be consistent.
This implies that most of the items were cheaper a few years back, and most of them will become costlier in the future. There will be things that will become cheaper because of technological advances and innovation. I am not referring to such items when I am talking about inflation.
The things I am referring to are essential stuff that you would be consuming on a regular basis.
Let’s look at an imaginary scenario here. You have 1000 rupees in your pocket today, and you don’t do anything with it for the next five years. Will you be able to buy less, more, or the same amount of things as today?
In all probability, the buying power of 1000 rupees would have gone down in 5 years. So, you either spend that money on something important that you need today for which you expect a price increase or invest in some instrument so that the value of the money invested at least beats inflation.
Please remember, money sitting idle keeps losing its value over time. You need to find the right place to invest your money so that it grows at a suitable rate. Read the piece on investment basics by clicking here.
Present value of money
Photo by Aron Visuals on Unsplash
So, the question that we face now is – “What would be the value of that 1000 rupees five years later”? In other words, if you were to buy your basket of items with 1000 rupees 5 years later, how much would you have to spend today to buy the same basket? This is known as the present value of money.
There is a mathematical way to derive the present value of money. It is calculated as:
Present Value = Amount/(1 + Rate Change)Years
where, amount stands for the amount of money in the future. Years is the time difference between today and the future date when the amount would be available to you and rate change is the expected rate of change in the value of money each year.
The ‘rate change’ needs a bit more explanation. The other terms are easy are to understand, so they need no further explanation.
The rate change is the increase in the prices of the items (in percentage terms) you expect over one year. You can never be sure about the exact number, that is why I used the term ‘expect’. But you can use an approximate proxy for it. That would be inflation plus a margin on top of it.
Let’s compute the present value of the future 1000 rupee (5 years in the future). Assume inflation of 5%. I would add another 2% as margin on top of it. So, the ‘rate change’ would be 7%. So, the equation would be:
Present Value = 1000/(1 + 7%)5
The result is 712.99 rupees. This means that the basket of items you can buy today for 713 rupees, will cost you around 1000 rupees five years later. So, now you can see, how the value of money depreciates over time when you expect the prices to move in an upward direction.
Conclusion
The value of money is not constant. It changes with time. It is closely linked to inflation. The value of money generally depreciates over time. So, you must invest your money in the right places, so that the value of your money increases with time.
I wish you all the best with your money matters!!!