Values of Money
time is money++
Money has two values. Its value today and its value in the future.
What is the difference, and why does it have two values?
The value of money today is called the Present value of money (PV), and the future value is called that. (FV)
The difference between PV and FV is:
PV is the money you have now, which means you can utilize it right now. That is, you can either spend or invest.
FV is money you don’t have but expect to have in the future. This means there is a possibility that you never get to have the money.
This difference affects the way we look at money. If it is PV, then we value it more. If it is FV, we discount it.
Side note: this is similar to how we humans view rewards. If a reward is close by, we tend to value it more. If the reward is far into the future, we give it lesser value. This is called the present bias, Giving more weight to payoffs closer to the present time.
While it is a bias, in economics, it isn’t because the PV is truly worth more than FV because of mainly two reasons:
PV can gain returns (or interest) if invested. That is, if we are expecting X amount in the future, the same amount can generate returns before the date we are expecting the money. In essence, PV becomes more than FV because of the returns it has generated.
Inflation. Somehow, things tend to get more expensive with time. This means X amount today can purchase more goods than the same amount in the future. What $10 bought in the early 2000s is more than what it can buy today. Similarly, what it can purchase today will be more than what it will buy in the next ten years.
Caveat: Sometimes, the difference doesn’t matter much, so you do not care.
Present value states that an amount of money today is worth more than that same amount in the future.
What does all this mean?
It means there is a more significant benefit to receiving a sum of money now rather than an identical sum later. This is the concept of the time value of money.
where:
PV=Present sum of money (amount at the beginning of the period)
FV = Future sum of money
i=Interest rate at which the money compounds each period
n= number of periods (usually years)