Monday, February 05, 2007

Value of Money Vs Cost of Money 1

Value of money Vs Cost of Money:

“Value of money” corresponds to inflation and “Cost of money” corresponds to the state of the markets.

For example,

I buy a house for Rs 10 Lakhs today. For this, I procure a loan of Rs 8 Lakhs at an interest rate of 8% per annum.

Fast forward to two years from now --- the price of the house has gone up (appreciated) by 10 %. So the new value of the house is Rs. 11 lakhs. Now, the interest rate on my home loan has also gone up by 10%. The new interest rate is 8.8% per annum. Hence the cost of my home loan has gone up since I need to pay more interest for the same amount of money than I did two years back.

Now, as an investor, I want to know if the value of my money has gone up or come down vis-à-vis the cost of my money (or the money that I invested)

Let us take another angle to this:

Suppose I have a salary of Rs 300 per month today. The price of the “basket of goods” is (to simplify) Rs 200.

Fast forward to two years from now --- my salary has gone up to Rs 400. On the other hand, the cost of the “basket of goods” has gone up to Rs 300.

Now, how do I know if the value of my money (can afford the same basket of goods while saving the same amount of money as I did two years ago) is compensating for the cost of my money (I spend one month of my time to earn this money..Has the level of my financial independence improved by staying with the job?)


Is it possible, under any specific circumstances, for the two values to be the same?

This is debatable.

Is there a co-relation between these two values? E.g. cost of money goes up when value goes down?

There could be. Taking the example of my house --- the cost of money (interest paid on the home loan) has gone up. Think of the impact this will have on people who want to buy a new house. They will be discouraged with the increased interest rates. Maybe, a 10% increase does not matter much…but consider what happens if the interest rates increase by 20%, 30% … People will be less interested in buying a house. As a result, there will be fewer prospective buyers for my house (if I decide to sell it to get rid of the expensive home loan). Hence, the value of my money may no longer be Rs 11 Lakhs.

On the other hand, if the interest rates on home loans (or loans in general) are going up, you can be sure that interest rates on other financial instruments such as Fixed Deposits, Post Bank funds etc have also gone up. This could trigger an increase in the value of your money (i.e. you are getting more bang for your bucks lying around in banks and post offices than you did earlier)

It is a zero-sum game out there. The total money in the market remains the same at all times. Money changes hands only due to the perception flow in the market.
But the above is only a hypothesis. I am not an economist.

Alas !