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Financial Knowledge Assessment: Bonus Answer

Bonus.  Assume that the annual rate of inflation is 5%. Which of the following is the worth the most?

  • A.  $1000 today
  • B.  $1040 one year from now.
  • C.  $85 per month for one year starting at the end of the month.
  • D.  $500 today, and $520 one year from now.

Explanation:  If you understand inflation as it relates to purchasing power, then you got this answer right.  This question, like question 1, also deals with the impact of inflation.  The correct answer is “A. $1000 today.”  Pay attention to the effect that inflation has on purchasing power.

Before we begin, we must first understand what inflation is.  Inflation is the rate at which the general level of prices for goods and services is rising, and consequently, the purchasing power is decreasing.  Purchasing power is the value of a currency expressed in terms of the amount of goods and services the one unit of money can buy.  Purchasing power is just a fancy term for how much stuff you can buy with your money.

Actual value adjusted for inflation

Option A:  $1000 today has the same purchasing power as $1050 one year from now (see calculation below).

Option B:  $1040 one year from no change in purchasing power.

Option C:  Using a future value formula explained below, you arrive at a purchasing power of

                  $1043.70

Option D:  $500 today has the same buying power as $525 one year from now, plus the $520 that you receive in

                  a year, which brings the total buying power to $1045.

*Option A.  To calculate the purchasing power of $1000 today one year from now, you simply multiply $1000 by 5% to get $50.  Then add the $50 dollars to the $1000 to get a purchasing power of $1050.  The $50 represents the additional cost it would take to purchase the same item today due to inflation.  Note that if you were to receive $1000 today, it won’t magically become $1050 one year from now.  This calculation simply reflects the purchasing power that you have today.  Again, another simple way of understanding it is that buying $1000 worth of stuff today, will cost $1050 to buy the same stuff one year in the future.

*Option B.  No calculation needed because the 5% inflation rate that occurred across the year does not affect the money you would receive one year from now.  This option you have the ability to buy $1040 worth of stuff one year from now, which is less stuff than what you could buy in Option A.

*Option C.  The formula used to calculate the total purchasing power one year from the first payment of $85 is shown below.

P    =  purchasing power

    = payment

    = inflation rate

    = number of payments

Because we know , , and , we can calculate the purchasing power across the life of the payments.  We know that the payment( ), every month is $85.  We know that the number of payments( ) is 12.  The only initial math we need to do is calculate the per month inflation rate( ) which is simply 5%/12, because we have to divide the annual inflation rate into 12 monthly amounts.  We arrive at a per month inflation rate of .4167%.  Now we simply input all of the numbers into the equation above and get a total purchasing power of $1043.70.

*Option D.  This is simply a combination of the calculations that we did in “A” and “B.”  You simply multiply $500 you receive today by 5% to get $25. Then add the $25 dollars to the $500 you received today and the $520 you will receive in one year to get a purchasing power of $1045. The $25 represents the additional cost it would take to purchase the same item today due to inflation.

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