Economic Discussion

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Guys let’s have a discussion about a super important economic concept. We see this at work behind the scenes in our everyday life. It is called “time value of money”. Let’s take a look:

Would you rather have five dollars today or five dollars and fifty cents in a year from now? I would wager that most said that they would prefer five dollars today. Whether or not you are conscious of it, you probably understand the time value of money. For various reasons, money is more valuable in the present than it is in the future. There are all sorts of equations and thought processes that seek to explain the phenomenon; however, it is quite simple in my mind. The logic is based off what you can do with the money in the meantime.

As we all know, money can be used for many things. It can be saved, spent, invested, etc. All of these activities provide benefit to the transactor. Traditionally, the time value of money is founded on the benefit of saving that money and earning a compounded interest rate. Here is the fancy equation that I was referencing previously:

FV = PV x [ 1 + (i / n) ] (n x t)

Where future value equals present value, times one plus the interest rate earned, divided by the number of compounding periods per year (this can vary), to the power of number of compounding periods per year, times number of years.

The key takeaway from the equation is simply that there is value in having money now versus having money in the future, as there is a small amount of money that can be made in the meantime. Moreover, the amount of value is fluid and undetermined. If your money is simply held in a savings account, you will typically earn a little bit less than 1% per year. Though this does not seem like much, it is not moot. Time value of money becomes even more realized if you are being more aggressive with your money. Say that you are invested in a mutual fund that seeks to earn a conservative 7% per year. In this case, your money becomes even more valuable in the present, as you can take more advantage of having that money now. But going back to the 1% interest in a traditional savings account, having $1,000 now would be equal to having $1,010 in a year.

We have already examined how having the ability of saving and investing money creates value in having money sooner rather than later. Additionally, I suggest there is a third thing that gives present money value – that thing is spending. This mechanic relies more on human psychology than mathematical formulas. Having a desire for something, whether it is a house, car, pair of shoes, TV, etc., has the ability to distort logic. We have all been in a situation where we know that something will be on sale soon, or have a decreased price in one way or another in the future, however we did not have the ability to delay our urge, and ended up buying this thing immediately, ultimately costing us money. This is certainly human; however, it does demonstrate how having the ability to buy something now also serves to give present dollars added value over future dollars.

Time value of money is an accepted fact and can be leveraged. Does anyone know about any businesses that our using the phenomenon to support their business model? I would be really interested to learn. Let’s discuss!

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October 16, 2020 at 01:38AM

By admin