Harold's parents have offered him a $10,000 high school graduation gift with an option for another $20,000 upon graduation from college in four years
His friends tell him this is a $30,000 gift from his parents, but Harold already knows something about the time value of money. If the expected inflation rate over the next four years is expected to be 4% per year, what does Harold think the gift is worth in today's dollars? How should he explain his thinking to his friends?
What will be an ideal response?
Answer: First, Harold must calculate the PV of his gifts. He calculates a value equal to $10,000 + = $27,096.08. Harold should explain to his friends that a dollar today has a different value than a dollar in the future due to opportunities and purchasing power. The promise of $20,000 in four years, while generous, is worth less than $20,000 today because you must forego consumption for a period of time. When you are able to use the money in the future, goods will cost more than they do now. Thus, you will be able to consume fewer goods. In addition, if you had the money now you would have the opportunity to invest it, so that in four years the value could exceed $20,000.
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