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Money Definition and Function

Money Definition and Function

What is money? What are some of the functions and characteristics of money? Why are the pieces of paper in your pocket called money?

You'll be able to answer all these questions after reading this article.

Definition of Money

The definition of money refers to any asset that you can use to exchange goods and services. That is to say that anything that the other party will accept as payment, and give you a good or service in return, is money.

The definition of money has evolved with time, and today, it is not what it has once been. However, the principle and its use of it have remained the same.

Money: Definition and Functions US dollars StudySmarterFig 1. -US Dollars

When you go to a grocery store and try to buy apples, the cashier will ask you to pay in US dollars like the one seen in Figure 1. If you happen to have any foreign currency, you won't likely be able to purchase the good or service using the foreign currency, and instead, you will have to go to a currency exchange and exchange the foreign money into US dollars. You can only pay in US dollar terms.

Hence, we can say that the definition of money depends on the type of transaction you're performing. Although there are cases where you can exchange a good in return for another good, in most cases, the money as we know it today is the currency in circulation.

Usually, the most common types of money are the currency in circulation, which refers to the cash and coins in the hands of the general public, and any checkable deposits. You have checkable deposits if you have a bank account from which you write checks that the receiver then cashes out. These two types of money, currency and checkable deposits, are the most liquid forms of money. The more liquid the money is, the easier it is to perform transactions.

Now, the money supply is what we call the total value of money in the economy. It contains not only the most liquid forms of money but also financial assets and other types of money that are less liquid than cash or checkable deposits. There is more than one way to measure the money supply.

If you have stocks, they serve as a form of money; however, you will have to find a buyer for your stocks if you want to perform further transactions with them.

Importance of Money

The importance of money comes from its ability to provide efficient transactions in an economy. It is a means of exchange. Money is one of the most important tools in an economy as it allows transactions. In the absence of money, the transactions would become inefficient, and the economy will not be able to produce.

Think about it; if it weren't for money, there wouldn't be a good way to trade for goods and services to meet your needs. If you want to purchase some corn to eat, the farmer might only be willing to give you the corn if you have a chicken to give the farmer. Then you have to find someone who is willing to trade you a chicken for something else that you have just so that you can go trade the chicken to the farmer for the corn that you want! And you would have to do this for every single item that you want to acquire. What a mess!

Money narrows it down to just one item that can be used in order to purchase any good or service that we want or need.

Additionally, money allows for international trade to happen. The exchange of goods and other services from different countries is enabled by money, which is a means of exchange.

The cheap goods you buy on Amazon from China can be bought because you give US dollars in return. Imagine if you had to exchange another commodity such as milk for an iPhone case from China. You would have to acquire the milk and find a way to deliver it to China without it spoiling. It will be tough, almost unlikely, for this transaction to take place.

Characteristics of Money

The four main characteristics of money are durability, divisibility, transportability, and non-counterfeit as seen in Figure 2.

Durability

Refers to the physical ability of money to withstand damage, decomposition, or change of any sort. Money should and must be able to retain its durability.

Divisibility

This refers to money's ability to be divided into smaller parts while all the smaller parts have value. $100 equals two $50 notes, and both have the same value.

Transportability

Transportability is money's ability to be easily carried around, which makes it possible for individuals to perform transactions when they go out.

Non-counterfeit

Money can't be easily counterfeited. People need to trust that money is not likely to be counterfeit. Otherwise, all of our money would quickly lose value, and vendors would not want to accept it for payment purposes.

Functions of Money

Functions of money include the medium of exchange, store of value, and unit of account as seen in Figure 3. Any asset that has all of the following functions is considered to serve as money.

Medium of exchange

A medium of exchange is an intermediate tool used to enable the sale, purchase, or transfer of products between parties. For a system to operate as a medium of exchange, it must represent a standard of value. Further, all parties involved in the transactions must accept it. In contemporary economies, the most common means of trade is cash.

Store of value

Store of value refers to the ability of an asset to hold its purchasing power over time. For one asset to be considered money, it has to have value over time. If you have an asset that will decrease in value in a short time, it can't be considered money. For it to be considered money, it must have value for a long period, meaning that you can still buy goods and services with it.

Imagine having money that today can get you ten apples, but no one accepts it the following day, and your purchasing power disappears into thin air.

Unit of account

Another essential function of money is the unit of account. This means that the money can be measured based on goods and services it can buy. This means it can be used to set prices for goods and services that people want to consume.

For example, imagine that you need $1,090 to buy a MacBook Pro. This means that the value of a MacBook can be measured in terms of money. This is one of the most important characteristics of money, as all goods and services in the economy are expressed in money terms--that is, prices.

You have housing rental rates that are expressed in terms of dollars; the goods at your local grocery store are also described in terms of dollars—basically, anything in the economy.

Is Bitcoin money?

To answer whether Bitcoin is money, you have to look at the characteristics of money. While Bitcoin has grown to be a medium of exchange and a store of value as it is widely accepted worldwide and its value has appreciated over time, many argue that it is hard for bitcoin to be a unit of account. The reason for that is due to fluctuations in Bitcoin's price.

Exchange means as a Function of Money

We previously introduced the concept of money as a medium of exchange.

Money allows anybody who has it to engage in the market on an equal basis with everyone else. A bid is successfully made when a customer uses the money to acquire an item or service that has been advertised at a certain price. This brings order and the ability to predict in the marketplace.

Producers know what they are going to produce and how much they will charge, and consumers can plan their budgets with confidence around predictable and stable pricing structures. The entire transaction is facilitated by money which serves as means of exchange.

If money, as represented by a currency, ceases to be viable as a medium of trade or if its monetary units can no longer be reliably valued, consumers will lose their capacity to effectively and efficiently perform transactions in the economy.

Imagine how hard it would be to exchange using goods. Finding someone who not only has what you're looking for but also demands what you are willing to trade.

Usually, you have the domestic currency of a country serving as a medium of exchange. However, in cases when severe recessions/depressions are hitting a country's economy, they may switch to alternative currencies and use them as a medium of exchange. That is because, in times of crisis, currencies lose value quickly, and the purchasing power drops.

During the recent Lebanese economic crisis, the use of the dollar as a medium of exchange became much more prevalent as Lebanon's currency was losing its value.

There were other alternatives to the currency that were used as a medium of exchange in times of economic crisis throughout history. One typical example of an alternative medium of exchange includes the use of cigarettes in prisoner-camp during World War II. Prisoners were exchanging cigarettes for goods and services.

Store of value as a Function of Money

Essentially, any item, money, or commodity that can be consistently turned into another asset, currency, or commodity at a later period may be used as a store of value. An item's eligibility as a store of value is determined by its ability to be stored, retrieved, and traded while retaining its buying power under any given circumstances.

Risk aversion is the basic idea of a store of value, and prices will be maintained as long as there is a continuous demand for the underlying object.

For example, gold and other precious metals are considered "stores of value" since they provide utility due to their extended shelf life and do not depreciate in value over time.

Stores of value also include interest-bearing assets, which qualify as such since they provide income while simultaneously retaining their worth. A commodity, on the other hand, such as milk, is a poor store of value since it is perishable and will expire in due course, rendering it useless.

Throughout much of history, many commodities served as money in various forms. Initially, trade agents relied on assets and commodities, such as gold, as means of exchange because of their inherent worth, durability, and mobility, as opposed to currency.

Generally speaking, money is regarded as a store of value in the monetary system, where it may be utilized to store and transfer capital. Money's ability to act as a store of value makes it easier to move buying power over a period of time.

Because cash has the ability to transmit buying power from one time to another, it is an excellent means of storing value.

For example, when individuals keep money in their pockets until they wish to trade it for products or services, the value of the money remains stable.

Money Definition and Function - Key Takeaways

  • The definition of money refers to any asset that you can use to exchange for goods and services you want.
  • The importance of money comes from its ability to provide efficient transactions in an economy.
  • Fiat money is declared by a government to be the medium of exchange and has no intrinsic value or backing.
  • The four main characteristics of money are durability, divisibility, transportability, and non-counterfeit.
  • The functions of money include being a medium of exchange, a store of value, and a unit of account.
  • A medium of exchange is an intermediate tool used to enable the sale, purchase, or transfer of products between parties.
  • An asset is a store of value if it has the ability to retain its purchasing power over time.

Frequently Asked Questions about Money Definition and Function

The definition of money refers to any asset that you can use to exchange goods and services for. That is to say that anything that the other party will accept and give you a good or service in return is money.

The importance of money comes from its ability to provide efficient transactions in an economy.

Efficient transactions

International trade. 

The four main characteristics of money are durability, divisibility, transportability, and non-counterfeit.

Functions of money include medium of exchange, store of value, and unit of account. 

Final Money Definition and Function Quiz

Question

What are the main types of money?

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Answer

The main types of money include fiat money, commodity money, fiduciary money, and commercial banks money. 

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How does the Fed measure the money supply in an economy?

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Answer

The Fed uses monetary aggregates to measure the money supply in the economy. Monetary aggregates measure the amount of money that circulates in the economy.

 

There are two types of monetary aggregates used by the Fed, M1 and M2 monetary aggregates. 

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Explain M1 monetary aggregate.

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Answer

M1 aggregates consider the money in its most basic form, the currency that circulates in an economy, checkable bank deposits, and traveler's check. 

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Explain M2 monetary aggregates.

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Answer

M2 aggregates include all the money supply M1 covers and add some other assets such as saving accounts and time deposits.

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What does M1 and M2 provide?

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Answer

The money supply in an economy.

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What is fiat money?

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Answer

Fiat money is a medium of exchange that is backed by the government and nothing else. Its value is derived from its official recognition as a medium of exchange from government legislation. 

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What's the difference of fiat money and representative money?

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Answer

Fiat money is a medium of exchange that is backed by the government and nothing else. On the other hand, representative is a type of money that is issued by the government and backed by commodities such as precious metals like gold or silver. 

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How is the value of fiat money determined?

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Answer

The value of fiat money is determined by supply and demand, and it was created as a substitute for commodity money and representational money in the early 20th century.

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What's the drawback of fiat money?

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Answer

The fact that fiat money is not connected to tangible assets, such as a national stockpile of gold or silver, means that it is susceptible to depreciation due to inflation. In the case of hyperinflation, it may even become worthless. During some of the most severe occurrences of hyperinflation, such as the period after World War II in Hungary, the inflation rate might more than quadruple in a single day.

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What is commodity money?

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Commodity money is a medium exchange with intrinsic value due to its use for purposes other than money.

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What are examples of commodity money?

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Examples of commodity money includes commodities such as gold, silver, copper.

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What is the drawback of commodity money?

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Answer

Although the use of commodity money has been historically wide in conducting trade between countries, especially using gold, it makes it significantly hard and inefficient to perform transactions in the economy. One main reason for that is the transportation of these goods that will serve as a medium of exchange. Imagine how hard it is to move gold worth millions of dollars around the world. It is pretty costly to arrange the logistics and transportation of large bars of gold. Moreover, it can be risky as it could be hijacked or stolen. 

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What is representative money?

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Answer

Representative is a type of money that is issued by the government and backed by commodities such as precious metals like gold or silver. The value of this type of money is directly linked to the value of the asset that is backing the money. 

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What is the difference between fiat money and representative money?

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Answer

The difference between fiat money and representative money is that fiat money gets its value from demand and supply. In contrast, the value of representative money depends on the asset's value it is backed by.


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What is fiduciary money?

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Answer

Fiduciary money is a type of money that gets its value from both parties accepting it as a medium of exchange in a transaction.

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What is commercial bank money?

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Commercial bank money refers to money in an economy that is created through debt issued by commercial banks.

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How is commercial bank money created?

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Banks take client deposit and then loan a portion to other clients. The reserve requirement ratio is the portion of deposits banks can lend to different clients. The lower the reserve requirement ratio, the more funds will be loaned to other people, creating commercial bank money. 

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Question

What is money?

Show answer

Answer

The definition of money refers to any asset that you can use to exchange goods and services for. That is to say that anything that the other party will accept and give you a good or service in return is money.

Show question

Question

What is the importance of money?


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Answer

The importance of money comes from its ability to provide efficient transactions in an economy.

Show question

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What are the characteristics of money?


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Answer

The four main characteristics of money are durability, divisibility, transportability, and non-counterfeit.

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What are the functions of money?


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Functions of money include medium of exchange, store of value, and unit of account. 

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What is the money supply?

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Answer

The money supply is the total value of money in the economy. It includes financial assets and and types of money which are less liquid than cash or checkable deposits. There is more than one way to measure the money supply

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What are the most liquid forms of money?

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Currency and checkable deposits are the two most liquid forms of money. The more liquid money is, the easier it is to perform transactions

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What's the relationship between the liquidity of money and ease of performing transactions?

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The more liquid the money is, the easier it is to perform transactions.

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What would happen to transactions in the absence of money?

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In the absence of money, the transactions would become inefficient, and the economy will not be able to produce. 

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Explain durability as a characteristic of money.

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Durability refers to the physical ability of money to withstand damage, decomposition, or change of any sort. Money should and must be able to retain its durability.

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Explain divisibility as a characteristic of money.

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Answer

This refers to money's ability to be divided into smaller parts while all the smaller parts have value. $100 equals two $50 notes, and both have the same value.

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Explain transportability as a characteristic of money.

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Transportability is money's ability to be carried around, which makes it easier for individuals to perform transactions when they go out.

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Explain non-counterfeit as a characteristic of money.

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Money can't be counterfeit. If money could be easily counterfeit that it would quickly lose value, and people won't accept it for payment purposes. 

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Question

Explain medium of exchange as a function of money

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Answer

A medium of exchange is an intermediate tool used to enable the sale, purchase, or transfer of products between parties. For a system to operate as a medium of exchange, it must represent a standard of value. Further, all parties involved in the transactions must accept it.

In contemporary economies, the most common means of trade is cash.

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Explain store of value as a function of money.

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Answer

Store of value refers to the ability of an asset to hold its purchasing power over time. For one asset to be considered money, it has to have value over time. If you have an asset that will decrease in value in a short time, it can't be considered money. For it to be considered money, it must have value for a long period, meaning that you can still buy goods and services with it. 

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Explain unit of account as a function of money.

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Answer

Another essential function of money is the unit of account. This means that the money can be measured based on goods and services it can buy. 


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What's a common medium of exchange in a country?

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Answer

Domestic currency.

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What happens when there are recessions/depressions to currency as a medium of exchange?

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Usually you have the domestic currency of a country serving as a medium of exchange. However, in cases when severe recessions/depressions are hitting a country's economy, they may switch to alternative currencies and use them as a medium of exchange. That is because, in times of crisis, currencies lose value quickly, and the purchasing power drop. 

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What is present value?

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The present value refers to the current value of an amount of money or stream of income that will be received at a future date.

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What are advantages of present value?


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Present value is beneficial in accounting for inflation while calculating the current value of your future income.

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What is an example of present value?


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One example of using present value is deciding whether a share of stock that pays annual dividends is worth the current price of the stock. Almost any investment relies on comparing the current value of a stream of future income to the cost of the investment.

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What is future value?

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Future value refers to the worth of money at a particular specified time in the future. A nominal amount of money received in the future, say $10 one year from now, is a value at a future point in time. This future value would have to be converted to present value to understand how much it is worth today. Conversely, if we have a certain amount of money today, we can calculate its future value at a specific point in time by discounting it to account for the time value of money. Simply said, money now is worth more than the same amount of money in the future.

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What is the assumption future value is based on?

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The FV equation is based on the assumption of a constant growth rate, a single initial payment that remains unchanged throughout the investment's lifespan, and a risk-free option.

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How do investors use the FV?

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When using the FV calculation, investors may forecast the amount of profit that different types of investment opportunities can earn with differing degrees of accuracy.

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What is the difference between present value and future value?

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The main difference between present value and future value is that the present value shows the current worth of money received in the future. In contrast, future value shows the value of today's money in the future. Money now is worth more than the same amount of money in the future.

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What is the discount rate?

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The discount rate is typically the interest rate or the guaranteed rate of return that you can get on an alternative investment. The discount rate is used to calculate the present value of an asset, over and above the opportunity cost of the investment--the next best option. It's called the discount rate as it discounts the future value of money to make it comparable to money in the present.

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If the interest rate in an economy was 8% what would be the discount rate used in the present value formula?

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Answer

The discount rate would also be 8%.

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Question

Explain the number of periods (n) in the present value formula.

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Answer

The number of periods refers to the time duration considered for the longevity of the investment. It could be daily, monthly, yearly. It basically shows how much money is growing throughout the considered period. If the number of a period is ten years, it shows how much worth $1000 is worth today vs. ten years from now.

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What is the importance of using present value?

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One of the most important aspects of using present value is to account for inflation and loss in purchasing power.

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If an economy experiences a 10% increase in inflation, what is the real value of $1,000 the following year?


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Answer

One of the most important aspects of using present value is to account for inflation and loss in purchasing power. If an economy experiences a 10% increase in inflation, meaning that the price of goods and services increased by that particular percentage, the money in your pocket will also lose value. $1000 would buy you $900 worth of goods and services in the following year after the prices have increased by 10%.

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What are some applications of present value?

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Answer

Present value is important in valuing assets and bonds in the financial market. Present value helps inform investors about the value of an asset in today’s terms. 

Also, it helps investors navigate through the various assets and securities they can invest in.

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What are the present value assumptions?

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Answer

Present value accounts for money losing value over time, and assumes there is a constant annualized rate of return one makes from investing and there is an alternative rate of return that can be guaranteed in some way.

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Question

The definition of _______ has changed over time, and refers to any asset that you can use to exchange goods and services.

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Answer

Money

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Question

Which of the following is not a typical type of money?

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Answer

Bonds

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