Hi, Else here.
And today we're going to talk about the time value of money.
Before we can do any calculations,
I want to talk about the concept.
After all, without understanding the concept,
it's possible to do the calculation.
The time value of money says that $1 in your hand
today, say on February 20, is worth more than $1 in your hand
on February 20 next year, 365 days from now.
The question is, why is that true?
When I ask students what is the time value of money,
that's usually their explanation.
But the question is, why is it true?
There are actually two reasons--
inflation and opportunity cost.
Let's look at each of these individually.
Inflation is a general increase in prices,
because over time the prices of things keep rising.
Because the price of things, and by this I
mean goods and services, keeps rising, the purchasing power
of your money--
the amount of goods and services that the same amount of money
can buy--
is actually decreasing over time--
sometimes quite dramatically.
What causes inflation?
There are actually three things.
The first is cost push inflation.
The cost of goods and services provided
by businesses rise and that increase
is passed on to customers.
It could be because the cost of resources used by businesses,
such as raw materials, labor, or land is increasing.
Any cost pressure on a business will
be passed on to the customers in the form of higher prices.
If businesses didn't do this, they
would become unprofitable and go out of business.
The second factor is demand inflation.
This is when demand for goods and services increases,
but the supply stays the same.
This means that more people want the same thing.
And, because they want these things,
they are willing to bid up the price of the good
or service in order to get it before anyone else does.
A good example of high demand and low supply
would be the availability of houses during 2016 and 2017
in Toronto, Ontario.
The supply of houses available for sale was low,
but demand was high.
The result?
House prices skyrocketed.
For instance, in early 2017, a house for sale in Toronto
listed for $1.19 million for $1.5 million
above the asking price.
The increase in the price of this house
was due to the owners receiving 35 offers in one day.
Many people wanting the same thing bids up the price--
sometimes, astronomically.
Demand inflation is usually caused
by people getting richer.
They have more money to spend on goods and services,
and their demand for goods and services
actually causes prices to increase.
Anytime something happens to make people richer,
there will be demand inflation.
The third cost of inflation is governments making more money
available.
In order to stimulate the economy,
governments may either print money, increasing
the number of dollars in circulation,
or increase government debt, which again puts
more dollars into circulation.
Why might this cause inflation?
Think about it like this.
If gold was so common that we could all dig it up
in our backyard like dirt, how much would gold be worth?
Very little, because there's a lot of it around.
It's the same with dollars.
If there are more dollars around then
each dollar will be worth less.
Why is that?
Because when there is a lot of money in circulation,
there are more dollars available to buy the same supply of goods
and services.
And you know what that will cause?
It'll cause the price of goods and services to be bid up.
You may have more dollars, but it won't buy you
more goods and services, because those goods and services will
increase in price due to higher demand.
Too many dollars chasing the same amount
of goods and services.
All right, let's recap.
Inflation is caused by three things.
First is cost push inflation.
As costs increase for businesses,
they pass the higher cost onto the customer
by charging higher prices.
Second is demand inflation.
When demand increases, but supply stays the same,
prices are bid up.
Third is government making more money available,
which reduces the value of every dollar
and again, bids up the prices for the existing
supply of goods and services.
Now that you know what inflation is,
can you see why inflation impacts
the value of money over time?
Let's look at our timeline to see it.
In 1961, a dozen eggs cost $0.30, but in 2017,
a dozen eggs cost about $3.25 or more,
depending on the type of egg you buy.
That means that the average price of a dozen eggs
has increased by 983%.
That's inflation.
We can also ask ourselves if the cost of services
changes over time.
Well, in 1961, a ride on the subway in Toronto on the TTC
costs $0.15.
In 2017, the cash fare to ride the subway was $3.25.
That's a 2067% increase in the price of a ride on the subway.
As you can see, inflation affects
the prices of goods and services over time.
So, if inflation causes prices to rise over time,
it means that if you have a choice between $1 today
and $1 tomorrow, you should definitely
take the dollar today.
Why?
Because the basket of goods you can buy with your dollar today
is a lot bigger than the basket of goods
you will be able to buy with that same dollar tomorrow.
That's because the buying power of your dollar tomorrow
is lower due to the effect of inflation.
What inflation was always 0%, meaning there was no inflation?
Now, that's not realistic, but let's
pretend that inflation is 0.
Would that mean that $1 a day is worth the same as $1 tomorrow?
No.
Even if inflation was 0, which is very unlikely,
$1 today would be worth more than $1 tomorrow.
Why?
Because of the opportunity cost, which we'll
discuss in a future video.