Why does money have a time unit and why do we need to account for it?

The answer is that there is an opportunity cost associated with not having money today. Specifically, with money in hand, we can “put it to work” in a financial sense. That is, we can invest it in a savings account, a certificate of deposit (CD), government bonds, corporate bonds, stocks, real estate, etc. By doing so, we earn money, or a “return,” on our investment. So, in the future, the money we had today will be worth something different and, on average, more than what we had today. Thus, when we consider money, we have to recognize that money received at different points in time really does have a different value.

Let me give you an example to emphasize this point. If I have $100.00 today, I can put the money in a savings account at my bank and at the end of one year I will have about $100.01 – sad but true in today’s low-interest rate environment. Alternatively, if I put the $100.00 in a stock-based mutual fund – an investment in a large portfolio of stocks – then I will have, on average, approximately $112.00 at the end of the year. (Yes, you do not really know exactly what you will have in the future and you could lose money but, on average, you will make about 12% per year.)

The implication of these investment opportunities is that $100 today is not the same thing as $100 one year from today because the money received in the future misses the investment opportunity. As such, $100 today is worth more than $100 in the future. And, this distinction has nothing to do with inflation, which we will discuss in the lectures as well.

Precisely what the $100 today will be worth, $100.01 or $112.00 in our example will depend on in what you decide to invest. If you invest in something relatively safe, like a bank savings account, the opportunity cost is relatively low – you will only miss $0.01 if you have to wait a year to get the $100. Alternatively, if you invest in something relatively risky, like a portfolio of stocks, the opportunity cost can be quite high – you will miss $12.00 if you have to wait a year to get the $100. Thus, the return on your investment represents the opportunity cost you face, and the risk of the investment determines the precise cost – low risk, low cost; high risk, high cost.

At the risk of redundancy, let me summarize. We have to recognize that money has a time unit identifying when it is received/paid. The reason is that there is an opportunity cost associated with money in the future; we miss the opportunity to invest it today. This cost is determined by the nature of the investment. If we invest the money in something relatively safe, then the opportunity cost is low. That is, the $100 received today will be similar to the amount of money we would receive in the future if we make the safe investment (savings account example). If we invest the money in something relatively risky, then the opportunity cost is high. That is, the $100 received today will be quite different from (less than) the amount of money we would receive, on average, in the future if we make the risky investment (stock portfolio example).