Question

If there were no inflation, a dollar today would be worth (LO5) a) exactly the same as a dollar received in the future b) more than a dollar received in the future c) less than a dollar received in the future

Short answer

In a situation with no inflation, the purchasing power of money remains constant over time, meaning that a dollar today would be worth exactly the same as a dollar received in the future. Therefore, the correct answer is: a) exactly the same as a dollar received in the future

Step-by-step solution

Scenario A: A dollar today is worth exactly the same as a dollar received in the future

Inflation refers to the general increase in prices and fall in the purchasing power of money over time. If there is no inflation, it means that the purchasing power of money remains constant over time. This means that a dollar today will have the same purchasing power in the future. So, in a no-inflation scenario, a dollar today is worth exactly the same as a dollar received in the future. This matches with option A.

Scenario B: A dollar today is worth more than a dollar received in the future

If there is deflation, which is the opposite of inflation, the purchasing power of money increases over time. In this case, a dollar today would be worth less than a dollar received in the future. This scenario contradicts option B.

Scenario C: A dollar today is worth less than a dollar received in the future

If there is inflation, the purchasing power of money decreases over time, meaning a dollar today would be worth more than a dollar received in the future. This scenario also contradicts option C. Considering the analysis of all three scenarios, we can conclude that:

Answer

A dollar today would be worth (LO5) a) exactly the same as a dollar received in the future

Key concepts

Purchasing Power

Purchasing power is a term that describes the value of a currency expressed in terms of the amount of goods and services that one unit of money can buy. In simpler terms, it's all about how far your money will go. Imagine you have $10. If prices go up due to inflation, that $10 won’t buy as much as it used to. However, if there's deflation, your $10 could potentially buy more. Purchasing power is affected by a variety of factors, but inflation and deflation are two major influences. Think of it as a seesaw; when inflation rises, purchasing power drops because your money buys less. On the flip side, during deflation, purchasing power increases and your money buys more.

• Inflation decreases purchasing power over time.
• Deflation increases purchasing power.

Understanding purchasing power is crucial since it determines how much you can buy now versus later. This concept is important for financial planning and evaluating the real value of money over time.

Deflation

Deflation is when the level of prices in an economy actually decreases. This is the opposite of inflation. When deflation occurs, the same amount of money buys more goods and services than before. In other words, your dollar gets stronger. Think about technology, for instance. Prices for electronic gadgets often drop because of advancements and increased efficiency, giving us more purchasing power for the same price over time. While deflation might seem beneficial because things cost less, it can be a sign of economic troubles, such as falling consumer demand or an oversupply of goods. A period with deflation might lead to:

• Increased value of money over time.
• Lower income for businesses, potentially leading to job cuts.
• Reduced consumer spending in anticipation of further price drops.

Hence, deflation can have a significant impact on the economy, affecting producers, consumers, and overall economic health.

Future Value of Money

The future value of money is critical in understanding how inflation and deflation impact finances. It's about projecting the value of an amount of money at a specified time in the future, based on a particular interest rate. This concept helps us determine how much money today will be worth in the future or how much today's saving might grow over time.To think about the future value of money, consider the interest earned on savings. Suppose you save \(100 now. With a compound interest rate of 5% per year, after one year, it would grow to \)105. Here's how it's calculated: \( FV = PV \times (1 + r)^n \)
Where:

• \( FV \) is the future value.
• \( PV \) is the present value (initial amount).
• \( r \) is the interest rate.
• \( n \) is the number of periods.

This concept is important for anyone planning for future expenses, investments or retirement savings. Understanding future value helps consumers make informed decisions about their finances and the impact of inflation on their savings.