If you are wondering why is a dollar today worth more than a dollar tomorrow, you should read on. Some people think it makes no sense, but it really does.
Have you heard the saying: a bird in the hand is worth two birds in the bush? Sure you have. But have you ever wondered what it means?
To understand the concept of money and its gradual loss of value, you must first grasp some basic understanding of money.
In this article we will explain why is a dollar today worth more than a dollar tomorrow and a few more basic money terms you should know.
Guide on why is a dollar today worth more than a dollar tomorrow
What is Money?
Money is a commodity that is typically exchanged to purchase goods and services. The benchmark of the global economy’s civilization, money is an entire language spoken and understood by everyone around the globe.
There are different variations of money that are used according to geographic location.
For example, the United States of America uses American Dollars, or the symbol $, which is proudly represented by the studded necklace many rappers choose to wear.
Canada and Australia use dollars too, but these are customized to represent their respective economies.
Other countries use other forms of currencies: for example, the United Kingdom chooses to use the currency Pound Sterling, popularized by the symbol, £.
Why Is A Dollar Today Worth More Than A Dollar Tomorrow
What is meant by Purchasing Power?
The purchasing power of your money is basically the power your money has to purchase goods or services.
This is a merry go round statement, but it is factually accurate. The purchasing power of any unit of money, regardless of currency, is the number of goods or services it can purchase.
This means that for everyone unit, let’s say, one dollar, the amount of things you can buy is the purchasing power that dollar has.
You might have heard your adults recall how they could buy more items with the same amount of money a couple of years ago than they can now.
“When I was your age…” may be the start of a very disappointing sentence, but sometimes, there is quite a bit of economic truth to it.
Things were cheaper when they were your age. Things are cheaper for you than they will be for the generation that follows.
What is the Purchasing Power Parity (PPP)?
But these currencies are not equivalent in value. A fickle macroeconomic concept dictates the purchasing power parity of the currencies used around the world.
For example, the US dollar, or USD, is worth only about 0.77 pounds, which means it is weaker than the latter in value.
The Purchasing Power Parity (PPP) compares the different global currencies to assess their strength to purchase goods and services. A country with a powerful parity has a stronger economy and a narrower exchange rate.
Similarly, a country whose economy is weak or developing, such as a third-world country, has a PPP that steeper with a wide exchange rate.
For example, a classic McDonald’s hamburger is more expensive in the United States than in India because the US dollar is 73 times as powerful as an Indian Rupee (INR).
What Is the Time Value of Money?
To understand why a dollar today has more value than a dollar tomorrow, you need to understand a simple financial concept fondly known as the time value of money.
The concept of the time value of money says that a dollar’s capability to purchase something today will reduce tomorrow. Let’s try this again.
This concept says that the purchasing power of a certain amount of money, for ease of understanding, a dollar, cannot help you buy the same number of things tomorrow as it can today.
It is represented by the mathematical formula:
FV = PV x [ 1 + (i / n) ] (n x t)
The formula stands for:
- FV= the worth of your money in the future
- PV= the worth of your money currently
- n= number of times the interest rate is compounded
- i= the rates of interest
- t= number of years
Why do things get expensive? Why does the money in your hand become less powerful as time goes on? To understand this, we need to understand the concept of inflation.
What is Inflation?
The previous section on the why is a dollar today worth more than a dollar tomorrow guide talked about time value of money. And in this section, we want to explain what is inflation.
The time value of money or TVM is an economic theory that proposes that a dollar that is in your hand today may not be able to purchase the same amount of goods tomorrow as it can today.
Suppose you can buy a Kit-Kat 500g bar for $1 today. In a couple of years, you may be able to buy only a 250g bar for $1.
The 500g bar of brand-name chocolate is still available in the market. But now it costs more than $1, for example, an arbitrary price of $2.
This increase in price means that the dollar you have right now will lose its ability to buy goods the same in the future. This change is caused by a factor called inflation.
A layman’s understanding of inflation is that it is the hike in the price of everyday goods, which, to be fair, is pretty accurate.
Inflation is a nominal indicator of the rate at which the average cost levels of a select group of goods and services rises over time.
This means that there is an increase in the overall price level, where a currency unit essentially buys less than it did in previous times.
Inflation is often calculated as a percentage increase in everyday commodities’ price, signifying the change (decrease) in the currency’s purchasing power.
A nominal unit of the nation’s currency loses its worth as prices increase. The worth of currency is gauged by its ability to purchase items available to be sold.
As prices soar, the currency in hand is able to attain less for the same denomination.
This, in turn, results in a loss of the purchasing power of the currency. It can then be said that the currency has lost its value.
The overall standard of housing for the population is influenced by this reduction of buying power, which inevitably leads to a slowdown of economic development.
The prevailing opinion among economists is that when a country’s spending exceeds the rate at which it earns money, the country faces a steady (but not ideal) increase in inflation.
There are three main reasons because of which a country may face inflation.
- Demand-Pull Inflation: Suppose you start a business wearing you sell socks with animated characters on them.
You make them in all sizes, colors, and stock a wide variety. Your country experiences a severe spell of winter that year.
The demand for quality socks increases. You receive more orders than you anticipated or even produced.
The demand outweighs the supply. Previously, you sold a pair of Bart Simpson socks for $10. You have 10 pairs in stock (it’s a small business).
15 people are interested in buying that pair of socks. You hike the price of the socks from $10 to $15.
Now only 10 people are interested in buying your socks. You sell out your entire inventory and make an unexpected profit (go buy that expensive winter coat now).
Demand-pull inflation occurs when an economy’s aggregate consumer spending rises faster than the economy’s output potential.
With higher demand and lower supply, a wedge develops between the demand and supply, causing an increase in prices.
This is known as demand-pull inflation.
- Cost-Push Inflation: Suppose you run a sock company (we really see you selling socks). The yarn you used to make a pair of medium-sized socks cost you around $2.
It was imported and came from the best cotton in Egypt. Now, due to inflation, the same yarn costs around $3.
To keep your profit margin constant, you increase the price of your Bart Simpson socks to $11.
Because of the increase in your production cost, you increased the price at which you were selling the product.
Cost-push inflation is a function of the rise in the prices of inputs from the manufacturing process.
A rise in the labor cost of making a good or providing a service or a rise in raw materials prices will result in higher prices and lead to inflation for the final good or service.
- Built-In Inflation: Suppose that along with your sock company, your equally business-savvy peers decide to launch their own startups.
All of you become successful, and because our hypothetical country only has 50 people, the country’s economy picks up and grows at an accelerated pace.
The standard of living of the individuals living in this country increases. They earn more now and can afford a better lifestyle.
This also means that they can afford to buy goods at a newer, higher price. So, the inflation (a rise in the price of goods) increases.
This is good news for the economy because it means that the countrymen and women are becoming richer and afford to buy better.
It also means that the purchasing power of the economy’s currency has increased.
It is simply the inflation that comes about due to the expectation that the economy may grow.
You feel like you will be richer tomorrow, so you buy more today.
Money and Opportunity Cost
Now that we have brushed up on some important concepts in the why is a dollar worth more today then tomorrow topic and sub topics like the time value of money, and the factor of inflation that causes it, you must be asking yourself: what can I do so that my money’s value does not decrease over time?
That’s a great question, and you’re thankfully not the first person to ask this. Otherwise, you’d have to figure out some challenging financial concepts by yourself.
Let’s study the phrase “make your money make money for you.”
Opportunity costs reflect the increase in benefits overlooked by a person, investor, or company when selecting one approach over the other.
A big principle in economics is the theory of opportunity costs. Each available alternative’s costs and advantages must be evaluated and measured against another to assess opportunity costs better.
To get a respectable grade, a person might give up going to see a film to prepare for an exam.
The opportunity cost is the expense of the film and the pleasure of watching it. Similarly, your opportunity cost for not going to work are the missed wages,
Considering the importance of opportunity costs, people and companies can be driven to more effective planning and decisions.
Investment in Stocks and Bonds
To have your money earn more money, you need to invest it. This means that you use the money you have to either buy shares in a business that is offering them or give out loans to people who are willing to borrow it from you.
For both these situations, you charge an interest rate. For example, you give a person $100 as a small loan today.
He will return the loan to you in two years. If he returns the money to you two years later, the buying power of the money will have reduced.
This means that you might make a loss. The opportunity cost you forgo to lend money to your needy friend should be covered by your profit.
The interest rate is the percentage paid for the use of wealth by a creditor to a debtor with the principal amount first paid.
Simple interest is used in most loans. However, some debts use compound interest, which is added to both the principal and the accrued interest of each of the periods completed.
There would be a reduced interest rate on a loan that is deemed low risk by the lender. There would be a higher interest rate on a loan that is regarded as high risk.
A stock market is a location where investors go to exchange equity instruments, such as ordinary shares.
There are securities traded in stock markets. Buying equity shares, or stocks, include buying a very minority interest of shares in a corporation.
Bonds are sold in a market where investors exchange debt securities, primarily bonds that companies or governments may issue.
The bond market is often referred to as the debt market or the credit market.
The bond traders and investors buy and sell fractions of loans to businesses or buy financial instruments issued by the government.
Usually, stocks trade on multiple markets, while bonds are traded mostly over the counter instead of in a consolidated venue.