In class, I made the following statement: "Starting from now on, every dollar value you see...

In class, I made the following statement:

"Starting from now on, every dollar value you see should have an 'invisible' time tag."

Explain carefully what the 'time tag' is and why the 'time tag' serves an important role for us in understanding the time value of money.

Expert Solution

Solution

Money has time value. A dollar today is more valuable than a dollar a year hence. We use rate of interest to express the time value of money.

In the statement - "Starting from now on, every dollar value you see should have an 'invisible' time tag" , 'time tag' refers to the time tagged with the dollar at a particular point of time and that time is used along with relevant interest rate to determine the value of dollar at a future date - Future value of dollar.

There are 3 reasons why time serves an important role in understanding the time value of money :-

(1) Preference for present consumption :-

Individuals have a preference for current consumption in comparison to future consumption.Inorder to forego the present consumption for a future one, they need a strong incentive.

(2) Inflation :-

Inflation means price of things rise faster than they actually should.When there is inflation, the value of currency decreases over time. If the inflation is more, then gap between the value of money today to the value of money in future is more. So, greater the inflation, greater is the gap & vice versa.

(3) Risk :-

Risk of uncertainity in the future lower the value of money. For example, non receipt of payment ,uncertainity of investor life or any othee contigency ,which may result in non-payment or reduction in payment.

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