Podcast
Questions and Answers
Why does money generally have a higher value today compared to the same amount in the future?
Why does money generally have a higher value today compared to the same amount in the future?
- Future earnings are taxed at a higher rate.
- The cost of goods and services always decreases over time.
- Inflation always decreases the absolute value of money.
- There is potential for earning interest or returns on money held today. (correct)
If you are indifferent between receiving €1000 today and a promise to receive €1050 in one year, what does this imply?
If you are indifferent between receiving €1000 today and a promise to receive €1050 in one year, what does this imply?
- The interest rate is -5%.
- The future value of €1050 is less than the present value of €1000.
- The interest rate is 5%. (correct)
- There is no time value of money.
What is the primary reason for the difference between the real and nominal interest rates?
What is the primary reason for the difference between the real and nominal interest rates?
- Exchange rates.
- Inflation. (correct)
- Government policies.
- Tax regulations.
What does the nominal interest rate represent?
What does the nominal interest rate represent?
If the nominal interest rate is 8% and the inflation rate is 3%, approximately what is the real interest rate?
If the nominal interest rate is 8% and the inflation rate is 3%, approximately what is the real interest rate?
What is the significance of the 'time value of money' concept in financial decision-making?
What is the significance of the 'time value of money' concept in financial decision-making?
What is the role of interest rate in lending money?
What is the role of interest rate in lending money?
If you deposit €2,000 in a bank at an annual interest rate of 7%, how much money will you have at the end of one year?
If you deposit €2,000 in a bank at an annual interest rate of 7%, how much money will you have at the end of one year?
Suppose a loaf of bread costs €2 today. If the annual inflation rate is 4%, what will be the approximate cost of the same loaf of bread next year?
Suppose a loaf of bread costs €2 today. If the annual inflation rate is 4%, what will be the approximate cost of the same loaf of bread next year?
A company promises to pay you €5,000 in two years. What concept do you use to determine how much that future payment is worth to you today?
A company promises to pay you €5,000 in two years. What concept do you use to determine how much that future payment is worth to you today?
You have the choice of receiving €1,000 today or €1,100 in one year. What would influence your decision if you apply the concept of time value of money?
You have the choice of receiving €1,000 today or €1,100 in one year. What would influence your decision if you apply the concept of time value of money?
Why is understanding the real interest rate important for investors?
Why is understanding the real interest rate important for investors?
How does inflation affect the value of money?
How does inflation affect the value of money?
What does it mean if the real interest rate is negative?
What does it mean if the real interest rate is negative?
You invest €5,000 at a nominal interest rate of 10%, but the inflation rate is 4%. What is the approximate real return on your investment?
You invest €5,000 at a nominal interest rate of 10%, but the inflation rate is 4%. What is the approximate real return on your investment?
Flashcards
Value of Money
Value of Money
The value of money is a relative concept measuring the goods and services it can buy.
Time Value of Money
Time Value of Money
Money's value depends on when the cash flow occurs; future flows are worth less than present flows.
Inflation
Inflation
General rise in prices, eroding purchasing power.
Interest
Interest
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Interest Rate
Interest Rate
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Real Interest Rate
Real Interest Rate
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Nominal Interest Rate
Nominal Interest Rate
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Real vs. Nominal Interest Rate
Real vs. Nominal Interest Rate
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Study Notes
- Money's value is relative, reflecting the goods and services it can purchase.
- €100 may cover a family dinner, shoes, or cinema tickets, illustrating its value.
- €1,000 holds greater value than €100 currently.
- €1,000 had more value 30 years prior.
- €1,000 possesses more value today than it will 20 years from now.
- The timing of a monetary flow affects its value; future flows are worth less than current ones.
- A core financial principle states that the same amount of money varies in value across time.
- €100 today is worth more than €100 in one year.
Factors Affecting Money Value
- Purchasing power diminishes due to inflation, a general increase in prices.
- With 5% annual inflation, a €100 good will typically cost €105 the following year.
- Inflation decreases money's purchasing power.
- Present value is definite, but future cash inflows are less certain due to risks like inflation and default.
Interest Rate
- Compensation is needed for lending money via debt contracts.
- Interest is payment for foregoing capital for a set period.
- The interest rate represents the price for capital and time.
- A 6% interest rate on a €1,000 deposit for one year means €60 is received at year-end.
- A 6% annual interest rate on a €1,000 deposit implies indifference between having €1,000 now and receiving €1,060 in a year.
- €1,060 in one year equals the value of holding €1,000 today.
- €1,000 is the present value of receiving €1,060 in one year.
- €1,060 is the future value of €1,000 today, one year later.
Real vs. Nominal Interest Rate
- Future cash flows relate to inflation, distinguishing interest rates.
- The real interest rate (r) reflects future consumption units gained by giving up one unit today.
- The nominal interest rate (i) is in monetary terms, indicating future monetary units gained by giving up one today.
- The amount of consumption from 100 monetary units depends on the current price level.
- The investor will ask for a nominal interest rate if renouncing current consumption and investing the money.
- If you deposit €1,000 at 6% for a year, you'll have €1,060, but it doesn't mean you're 6% better off if inflation is also 6%.
- Goods costing €1,000 last year now cost €1,060, equating to no real gain.
- In this instance, the real interest rate is zero, even though nominal interest rate is 6%.
- The relationship between real and nominal interest rates is: 1 + real interest rate = (1 + nominal interest rate) / (1 + inflation rate).
- An approximate relationship is: Nominal interest rate ≅ real interest rate - inflation.
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