Inflation and the Future Value of Money

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During the second year of his term, United States President Donald Trump was expected to receive $400,000 as his annual salary along with an extra $50,000 for personal expenses. In 1789, the first President of the U.S., George Washington, was paid $25,000, a sum that in today’s dollars would be equivalent to more than $647,000.

Calculating the historical value of money, which is generally considered to be a depreciating asset, is done by means of applying the Consumer Price Index. Calculating the future value of money can be accomplished by means of taken into account the CPI as well as the rate of Personal Consumption Expenditure, which is tied to the target rate of inflation.

In the U.S., the information needed to calculate the future value of money is provided by the Federal Reserve and by the Department of Commerce. If this calculation is being done for retirement purposes, the rate of interest paid by investment portfolios and financial instruments should also be taken into account.

The most simple calculation that can be used to determine the time value of money in the future does not take into account inflation:

Future Value = Present Value * (1 + Interest Rate) over compounded period

Using the formula above, $100 today would be $105 in one year if the cash is deposited into a financial instrument that provides an interest rate of five percent. When taking into account inflation rates, the factors in the formula change as follows:

Future Value = Present Value * (1 – Target Inflation Rate) over the years

Assuming the target inflation rate of 2.18 percent set by the Federal Reserve in March 2018, the value of $100 today will decrease to about $80 by the year 2028. It should be noted that the time value of money can also be determined during deflationary times; in this case, the target rate will be negative.

It should be noted that major economic and geopolitical events can greatly influence future value calculations. The crash of the American mortgage and real estate markets in 2008, for example, effectively reduced the purchasing power of the dollar until about 2012, and hints of deflation were felt in the economy.

Let’s say a shipping clerk who expects to retire in the year 2030 deposits $10,000 in an account that matches the target inflation rate of 2018. Upon retirement, that account will be worth $12,953; since this is not too much of a financial improvement, the shipping clerk should look into investments that would pay her more than $10,000 now instead of waiting for her account to mature.

When inflation is factored into time value calculations, individuals can get a more realistic view of their financial situation upon retirement. A couple who needs $50,000 to cover their household and living expenses in 2018 will need about $77,000 to keep the same lifestyle in 2038. These calculations are routinely made by financial planners as well as by the Social Security Administration when determining the poverty rate and the amount of monthly retirement benefits.