The Time Value of Money

Is a dollar always worth a dollar? OK, you sly fox – you caught us, it’s a trick question! And you guessed it – a dollar is not always worth a dollar. Sometimes a dollar is only worth 80 cents, and sometimes it is worth $1.20. (Say! You give us your dollars worth $1.20, and we’ll give you ours worth $0.80, in an even trade! Have we got a deal?)

But let’s think about this. How can it be? The value of a dollar changes dramatically depending on when you can take control of the dollar and invest it. The critical variable in the exact value of a dollar is time.

If someone owes you a dollar, do you want him to pay you today or next year? (Yes! Another trick question! The answer is, “Today.”) With inflation consistently destroying the purchasing power of a dollar, a year from now a dollar will be worth slightly less than it is today. “Inflation” is an economic term used to describe the gradual tendency of prices to rise over time. If inflation is 2% per year that means that prices, on average, will rise 2% over the next year, which in turn means that your dollar can purchase 2 cents less in a year than it can today. That’s right, all you mathematicians out there – with 2% inflation, a dollar today is worth only 98 cents in a year.

However, if you got the dollar back today, you could invest it. If you invested it (along with a few of its cousins, we hope) and your investment returned 10% over the course of the year then you’d have $1.10 at the end of the year. So your money would be growing instead of shrinking, and you’d be staving off the negative effects of inflation.