Money, Measurement, and Time Cost

Roles of Money

Existence of money improves standard of living, as it eliminates “double coincidence of needs”1. Medium of Exchange – asset used to trade for

goods and services2. Store of value – Non-perishable, holds

purchasing power of time3. Unit of account – Commonly accepted measure

used to set prices & make calculations

What is Money?

Any asset that can easily be used to purchase goods and services

Three money supply measurements, each more broadly defined and less liquid than the previous one: M1 = Currency in circulation + checkable bank

deposits + traveler’s checks M2 = M1 + savings deposits + money market

funds + small time deposits (CDs less than $100,000) “Near-moneys”

M3 = M2 + large (over $100,000) time deposits

Types of Money

Commodity money – A good with intrinsic valueCommodity-backed money – MOE without intrinsic

value but guaranteed by conversion on demandFiat money – MOE with value derived from its

official status as such Advantages – Takes up no real resources; amount

in circulation is decided by needs of the economy Disadvantages – Can be counterfeited; printing

too much can lead to inflation

Time Value of Money

In general, having a dollar today is worth more than a dollar a year from now

Time value is a consideration when evaluating projects, so economists use present value to make comparison easier – using interest rate to compare the value of a dollar received today with value of a dollar received later

Present Value Equation

To see the relationship between dollars today (present value, or PV) and dollars one year from now (future value, or FV) a simple equation is applied:

FV = PV (1 + r)Ex. Lending $100 to a friend at 10% interest for one year.

FV = $100 (1.10) = $110In other words, one year into the future, that $100 will be worth $110.

PV = FV/(1+r)PV = $110/(1.10) = $100

This tells us that $110 a year from now is worth only $100 in today’s dollars.

What if we were lending money for a two year period?FV= PV (1 + r)² = $100 (1.10) (1.10) = $121

Conclusions

Money today is more valuable than the same amount of money in the future

The present value of $1 received one year from now is $1/(1 + r)

The future value of $1 invested today, for a period of one year, is $1 (1 + r)

Interest paid on savings and interest charged on borrowing is designed to equate the value of dollars today with the value of future dollars