How does Money gain Value over Time?

“How you spend your time is more important than how you spend your money. Money mistakes can be corrected, but time is gone forever” - David Norris

The most commonly heard investing expression “Time is Money” is a true indicator of the nature of beast - Time literally is money. This basic concept is derived from peoples willingness to save or spend - essentially it is trade-off between the two.

You have the choice whether to defer expenditure now (save) in order to receive a greater amount in the future, or consume more now (borrow) with the realization that more needs to be paid back into the future. This is what drives the pure rate of interest in our economy - the rate of exchange between future consumption and current consumption - which is a comparison of the savings to be invested and the demand for borrowings to be acquired at any given time. If you save (or borrow) $100 today and expected to get (give back) $105 in the one years time, the pure rate of interest would be 5%(105/100 -1).

The pure rate of interest is known as the real rate of  interest rate which is the effective growth of your purchasing power and is not usually quoted in the media -  they use nominal rate of interest - and it is the real interest rate, that as an investor, you want to look out for because the real rate is the increase in your available purchasing power.

The nominal rate of interest is the real interest rate plus inflation. Inflation decreases your purchasing power and erodes the value of your money and therefore what you can buy. It is influenced by many different economic factors but mainly by the demand of goods growing faster than the rate at which the goods can be supplied - effectively driving prices up. If you had $100 dollars in saving, and expect to get back $105 in 1 one years time but inflation was at 2% - then you would want to get $107 or a 7% nominal interest rate to compensate for inflationary rate.

Example: If the Real Rate is 7% and the Nominal is 10% - Inflation is at 3% (10% - 7% = 3%)

Generally, a small level of inflation means that the economy is growing, and a weakening inflation rate means that the economy is becoming weaker - whether inflation is good or bad for you depends ultimately on the position of the Australia economy and your personal situation. The Reserve Bank of Australia, usually keeps inflation maintained at low constant rate.

The most important fact to be aware of regarding inflation is that when you are looking at investment returns - you want the real rate not the nominal!