Inflation

Inflation refers to the increase of prices of goods and services over time. For example, if you buy 100 apples at $1 today and assuming that you could keep the 100 apples for 1 year, at the price increase of 5%, the 100 apples would be worth $105.

If you did not buy the 100 apples in the beginning and decided to keep the $100 with you. One year later, the $100 would be able to buy $100/1.05 = 95.23 apples. It makes your money become smaller relative to the apples.

Using the above example, $100 is the future value of money. Because it can buy only 95.23 apples in year 1, the value of that $100 (in year 1) is worth $95.23 (at $1 now) now. The $95.23 is the present value of that $100 in year 1.

Deflation

Deflation is the reverse of inflation. If you now buy 100 apples and keep it for one year, the apples is sold for less, e.g. $95. In this case, your cash of $100 is worth more in one year's time than it is now. You can buy more than 100 apples with your $100 in one year's time than now.

A slight more complex example can be found in our NPV faq.

The same concept is now used in financial investment, where the price increase is now replaced by the discount rate, apples are replaced by shares/stocks/projects and the money remain as money. Learn more about it in the following web pages Present Value and Net Present Value.




New! Comments

Have your say about what you just read! Leave me a comment in the box below.