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Basic Financial Concepts: Inflation, Purchasing Power, and Time Value of Money

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During our lives, we are all affected by a few basic economic forces.  These forces can negatively or positively impact the experiences we have in saving, spending, and investing.  Everyone should have a basic understanding of these concepts and how they impact personal finances.

  • Inflation:  according to www.dictionary.com, the definition of inflation is “a persistent, substantial rise in the general level of prices related to an increase in the volume of money and resulting in the loss of value of currency.”  In basic terms, inflation means that the things we purchase get more expensive as time passes.  In the United States, inflation information is calculated and released by the Bureau of Labor Statistics in the form of the Consumer Price Index (CPI).  CPI includes a wide basket of goods and services purchased by U.S. consumers.  Each year, the annual rate of inflation is used to determine a range of policy activities, including the payment increase Social Security beneficiaries may receive each year.  As part of the Federal Reserve’s dual mandate, they are tasked with maintaining a steady and moderate rate of inflation.  In the 100 years between 1914 and 2014, the rate of inflation has been 3.2%, which means that one dollar in 1914 is the equivalent of $23.30 today.
  • Purchasing power or buying power: purchasing power is directly related to inflation in that inflation erodes the purchasing power of money.  The definition of purchasing power is “the value of money in terms of what it can buy at a specified time compared to what it could buy at some period established as a base.”  An excellent example of purchasing power is the comparison of the cost of a movie ticket in Chicago.  In 2014, $14 will purchase one movie ticket.  In 1978, $14 would have purchased 14 movie tickets.  In other words, the amount of goods that can be purchased with the same amount of money today will be less than it was in the past and more than it will be in the future.  Purchasing power is slowly eroded over time.
  • Time value of money: according to www.thefreedictionary.com, the principle of time value of money is defined as “a fundamental idea in finance that money that one has now is worth more than money one will receive in the future. Because money can earn interest or be invested, it is worth more to an economic actor if it is available immediately.”  In simple terms, money possessed today is worth more now than it will be worth tomorrow.  In light of the discussion of purchasing power and inflation, this makes inherent sense.  However, the second portion of the definition is critically important to understanding the principle of time value of money.  Money you have today can be invested and grown, which often results in having more money in the future.  Financial experts often say that the greatest tool investors have is time.  The longer money is invested, the longer is has to grow.  Therefore, starting to invest at a young age usually results in greater amounts of money in the future, simply because of time.

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