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Financial Literacy | Time Value of Money (Part2 | Chapter1)

March 20, 2017

 

PART2                KEY PRINCIPLES of FINANCE

CHAPTER1        TIME VALUE OF MONEY

 

Did you know that today’s $1 worth less than yesterday’s $1? Let’s take a look at an example to understand what that means.

 

This is RJ here at Wild West, in early 20th century.

 

The horse he is riding could be bought around $30-50 at that time. However, in order to purchase a horse in the United States these days, you would have to pay somewhere between $1,500-$3,000.

 

As you can see from the example, you have to pay much more today that what you will have paid in the 20th century to buy a product with the similar quality. But why is that so? Why is the value of money different over time?

 

The answer is interest rate.

 

If you keep some portion of your money in your savings account, interest will be paid to you periodically on the notional amount that you have in the account.

 

If we ignore default risk, in other words, if we completely ignore the possibility of your bank going bankrupt and fail to repay your deposits, theoretically the interest rate is a sum of real rate of interest and inflation premium.

 

This interest that accumulates in your account is normally small if you only look at for 1 period or 1 year.

 

Considering that the interest rate ranges between 0.5% to 1.5%, if you keep $100 in your savings account for 1 year, the interest at the end of the year is probably around $0.50 to $1.50, which is minimal.

 

However, if this accumulates over time, the amount can be quite large through compounding effect.

 

Considering that the interest rate has ranged between 0% to 30% historically in the United States, let’s assume that the interest rate stays at 3% over hundred years.

 

The $100 in 1900 would worth $103 in 1901, $106.09 in 1902, and so forth.

 

In 2017, the $100 that you deposited would worth $3,176. What this means is that $100 in 1900 would worth around the same as $3,167 in 2017. In other words, $100 today was only about $3.15 in 1900.

 

Now, going back to our horse example, you can now see why the horse prices are so dramatically different from what it is today and what it was in early 20th century.

 

In Finance, this concept of money having different value over time is called the “Time Value of Money”. This idea is one of the key principles of finance and is widely used as a critical assumption for various calculations and theories. 

 

Click here to watch this clip on YouTube.

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