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Define Time Value of Money

Founder and CEO, Transfin.
Mar 31, 2019 4:49 AM 4 min read

How to define Time Value of Money (TVM), the bedrock of any personal finance planning exercise. Well, money as a concept is so mainstream that we hardly stop in our tracks to wonder about its abstract nature. Can money lose its value with time? 


Think about it…a One hundred Rupee Note (or any other denomination for that matter) is after all just a piece of paper i.e. Possessing no “intrinsic value”.


Take one out and place it on a table. Notice what’s printed on it?


You will see some words in Capital Letters: “Reserve Bank of India”, “Guaranteed by the Central Government”, and my favourite “I Promise to Pay the Bearer The Sum of One Hundred Rupees”.


Why Money Today Would Always Trump Money Tomorrow?


It’s the same story with a Coin. A piece of Stainless Steel, Nickel Brass or some other nondescript alloy (again with almost zero “intrinsic value”) showcasing the State Emblem of India.


What do these words and signage signify? They represent a Guarantee from the Government (in plain speak a “Promise” of sorts) that if you pay someone using a One Hundred Rupee Note, you will receive One Hundred Rupee worth of goods or services.


No wonder the technical name for modern Money is Fiat Money (derived from the Latin fiat or “let it be done”). It has no intrinsic value. Nothing tangible (like gold, for instance) backs it. All it has is a Government Guarantee. And the system works because its participants “trust” it.


A person receiving the One Hundred Rupee Note trusts he/she can unlock its denominated Value in the future. The person making the payment trusts he/she will receive the requisite goods and/or service in exchange. Take the same One Hundred Rupee Note to a desolate island and it quickly becomes useless junk.


The aforementioned trust took us (as humanity) many centuries to achieve. Historical monarchies, thanks to attacks from enemy kingdoms, were not the most stable structures, and little wonder people were apprehensive about any guarantees they provided. That’s the reason why Representative Money (Paper Money backed by some tangible e.g. Gold), or Commodity Money (Money made from something possessing intrinsic value like Gold and Silver Coins, Salt blocks, peppercorns, fur pelts etc.) preceded Fiat Money.


Fun fact, the word “Salary” comes from Latin salarium, originally denoting a Roman soldier’s allowance to buy Salt.


Anyways, I digress. Now that we’ve established what gives Money its Value, I ask another question.


Can Money Lose its Value?


Best way to think of this is a thought experiment.


Let us take the story of students Vinay and Som, and their Professor Sengupta. Both Vinay and Som helped Professor Sengupta in his ongoing academic research and were paid Rs 1,000 each for their efforts. Vinay promptly went to his Bank and deposited his stipend. Som was the lazier of the two, and just let the Rs 1,000 sit in his wallet (a very unlikely scenario for a student but kindly grant me some latitude for the sake of storytelling).


Twelve months pass by. While Som’s Rs 1,000 is still the same, Vinay’s Rs 1,000 earned a 10% interest in the bank, becoming Rs 1,100. So, what happened here? Assuming no action, Som’s Rs 1,000 relative to Vinay’s initial Rs 1,000 lost some of its value within twelve months.


Think about it. If both Vinay and Som are Pen aficionados and their favourite Pen was priced at Rs 100 per piece twelve months back…while both could have afforded to purchase 10 Pens each then…now Vinay can afford to buy 1 additional pen.


But does this example represent the complete picture? Not really. We forgot to account for the second whammy affecting the value of Money…inflation (i.e. price rises)!


If the Pen was priced at Rs 100 a piece twelve months back, its price would have also increased an year later. Assuming it went up by 10% (not a very unreasonable assumption), the Pen twelve months later would be available for Rs 110. Now we see that though Vinay would be able to still buy 10 Pens an year later, Som thanks to his lethargy would only be able to afford 9 of them!


Never forget that Money just sitting around incurs the so-called Opportunity Cost of Waiting, exemplified by the forces of interest rates and inflation.


Why Money Today Would Always Trump Money Tomorrow? 


Welcome to Time Value of Money


That’s the reason why Money received today is more valuable than Money received tomorrow.


But wait, how do I preserve Time Value of Money?


Simple…ensure your Money earns an Interest Rate greater than the rate of inflation via suitable savings and investments.



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