The concept of the time value of money is one of the basics of economics. The time value of money has its origin in the principle that an amount of money in a different period can be valued differently. It is also necessary to keep in mind that the money must bear interest and that the present value is different from the value of a similar amount received later.
In other words, the current amount will be different in a year or two. According to representatives of this theory, the value of money changes over time, taking into account the income from the financial market.
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The concept of change in the time value of money
How is the decrease in value explained? The theory of the time value of money is based on three elements: inflation, the risk of lack of income and the particularity of this instrument.
Time value methods
These are applied when it is necessary to find any of the unknowns: the level of interest, the number of payments, the number of repayment periods, the value of the present and future level. When using these methods, it is usually necessary to know the values of the variables used in the calculation of the levels.
Financial calculations for valuation purposes are made on the basis of the accumulation, discount and annuity methods.
The first method is to bring the amount of money to a future level. The second method requires reducing the amount expected by the income that accrues during a given period. The third method is based on the reduction to a future level of the pool of money obtained as uniform income in a certain number of periods.
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Elements that affect the value of money
Thus, the main factors that affect the time value of money are the following:
- Profitability: obtaining a return on the investment made in production assets.
- Inflation rate: the growth of prices over a period of time.
- The risk associated with investments: the possibility of not recovering the money invested.
The value of the risk premium is determined by the judgment of the experts. When setting the discount rate, the interest rate of the banks and the rate of return are taken into account. The discount rate is defined as the rate of return. It can be derived from different investment opportunities.
The value of the interest rate is generally based on the return that the investment can bring to its depositors.
The concept of valuing cash over time is based on the fact that its value varies gradually with the market rate of return. When comparing finances, two terms are used: future value of funds and present value.
The first indicator is the total of funds currently invested, which will be converted after a certain period of time, taking into account the interest rate.
The current value is the amount of future income reduced money considering the interest rate set for the current period.
The value of the rate depends on the profitability and nature of the investment, the inflation rate and the risk associated with the investment.
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Money supply concept
The money supply is the stock of money in a country. It is used for the flow of funds, which is called the circulation of money.
The national money supply is formed by the sum of all the money of a country in the State, companies, credit institutions, households, accounts, purses, etc. The circulation of money is divided into cash and non-cash. Countries with developed market economies have a predominantly non-monetary circulation.
The concept of liquidity is used in relation to the monetary system, the credit and banking system, as well as the balance of payments system. It is the property of finances that must be used by its owner for the quick acquisition of the necessary goods. Liquidity can go up or down depending on how the money is held. For example, cash is much more liquid than non-cash.
Types of liquidity
The liquidity of the different forms of cash according to the degree of increase in its liquidity:
- Money in bank deposits.
- Money in bank accounts, checks, bills of exchange, credit cards.
- Cash, bills, coins, securities.
Thus, the time value of money is the change in the value of money, taking into account the income of the financial market during a given period. In addition, the effect of inflation on the speed of circulation of cash is explained by the fact that buyers multiply their purchases to protect themselves from the economic risks due to the decrease in the purchasing power of money.
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