Subject: Financial Management
Chapter: Two – Time Value of Money
price index increase is also published regularly. At present the wholesale price index inflation is around 3%. We willexplain this concept through an example.Example no. 1I had spent Rs. 100/- in getting a basket of commodities one year ago. If the rate of inflation is say 3%, now I will berequired to spend Rs. 103/- to get the same basket of commodities. How do we get Rs.103/-? Rs. 100/- x 1.03 = Rs.103/-. This means that due to “inflation”, the purchasing power of the local currency decreases with the passage oftime. This is exactly the concept of “time value of money”. In simple words, “time value of money” means that withthe passage of time, money loses its value.
Is there a situation in which the prices decrease over a period of time and opposite of “inflation” takesplace?
Usually in a developing country, such a situation does not arise, as the demand is always greater than supply.However currently Japan is experiencing “deflation” in which current prices would be less than the past prices. Thisis harmful to a developing economy, as units that save money would get very low interest or no interest. Hence therewill be no incentive for the units to invest money in bonds, fixed deposits etc.
Concept of Interest as compensation for loss of purchasing power due to “inflation”:
You keep money in a deposit with a bank. It could be a Savings Bank or a Fixed Deposit. What does the bank pay toyou? “Interest”. This is the “return” on your investment. Why should the bank pay interest to you? Let us enumeratethe possible reasons for the bank’s action.
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The bank does the business of lending. For this, it requires funds through deposits. It earns interest on loansand pays interest on deposits;
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With the passage of time, the purchasing power of money reduces. The same thing will happen to yourdeposit with the bank. The bank gives compensation to you for this loss in value of money;
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In case the bank does not pay interest, it will not get funds for lending. You will not keep deposits with it.You will choose other willing banks or avenues of investment.While all of them are correct, we are more interested in the second reason. Value of money erodes due to “inflation”as we have seen in the earlier paragraph. The rates of inflation would be different for different countries. Further, itcould be different for the same country at different times. Sometimes it could be high while at some other times, itcould be low.
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Would interest be less in case the rate of inflation comes down?
Absolutely. As an example, we have already seen what is happening in Japan. The Japanese banks are practically notpaying interest on deposits right now. The rate of inflation in the US is around 2% p.a. and accordingly the rate ofinterest on investment would be around 3% to 3.5% p.a. Thus the rate of inflation in a country and the rate of intereston investment are closely linked to each other. For further details, please look at the “Tier structure” of rates ofinterest given below.Consider Indian market conditions. Hypothetically if the inflation comes down to say 1%, the rat e of interest on bankdeposits and bank loans in turn would also come down. The banks would not pay the current rate of interest. If thestudents may recall in India, the rates of interest on savings are constantly coming down. This is the result of the rateof inflation coming down constantly at least till the last year.
Four tier structure for rates of interest in any economy
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“Rate of inflation coming down” - What does it mean? Does it mean that the prices of commodities are coming down
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the increase in prices of commodities is coming down? – Answer is: The increase in prices of commodities is coming down; in actual terms, the prices of commodities arenot reducing.
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