Time value of money (TVM) is represented by the difference in value of some dollar amount of money or cash flow(s) over a period of time, assuming one can earn some sort of return on the money available.
Simple interest is calculated on the principal only while compound interest is when one also earns “interest on interest.” Compounding may be used to describe moving a value or cash flow forward in time:
# of years=n
nominal rate of interest=i
FV = PMT(1+i)^n
You have $50,000 to invest. If you think you can earn 7.5% annually, how much might you accumulate in 30 years?
Discounting is known as the process of moving a value or cash flow backward in time:
PV = PMT/(1+i)^n
If you’d like to have $50,000 in 5 years, how much might you have to invest today assuming a 5% rate of return?
Real returns are sometimes described as the rate of return one receives net of inflation but may be more accurately calculated:
Real rate of return=r
One should consider the effect of taxes on earnings as well.
Inflation is defined as the price increase of consumer goods and services over a given time period. It is typically measured by price indexes that mark the fluctuation of the cost of either a specific or general basket of goods and services.
Each year the cost of food, drink, clothing, transportation, health care, recreation, education, and our necessary services increases or each $1 usually buys less of this basket of goods & services than it did the previous year.
The consumer price index (CPI) measures the changes in price levels of a basket of consumer goods and services. Personal consumption expenditures (PCE), most commonly used by the Federal Reserve, is similar, however, allows for the substitution of goods and may provide a more accurate picture of consumer consumption.
A U.S. dollar purchased .66149% less in 2015, than it did in 2014. It stands to reason that if the $1000 that was kept in the safe since January of 2014 was worth ~$6.61 less, or $993.39 in January of 2015. The $1000 is still $1000, but it just doesn't go as far; your purchasing power has decreased.
How might inflation influence your job selection, savings and investment choices?
How might inflation influence the rent vs. buy decision or mortgage selection?