What is Money?

Money is a medium of exchange that facilitates transactions in an economy by

eliminating inefficiencies in barter systems, such as the "double coincidence of
wants."
Functions of Money
Money performs several essential functions in the economy:
1. Medium of Exchange:
Money simplifies trade by acting as an intermediary, allowing buyers and
sellers to exchange goods and services without bartering.
2. Unit of Account:
It provides a standard measure to compare the value of goods and services,
enabling informed decision-making and pricing.
3. Store of Value:
Money retains its purchasing power over time, allowing individuals to save and
use it for future transactions.
4. Standard of Deferred Payment:
Money facilitates borrowing and lending by serving as a reliable means for
settling debts at a future date.
Characteristics of Money
Effective money possesses the following characteristics:
1. Acceptability refers to the willingness of people in an economy to recognize
and use a specific item (such as currency) as a medium of exchange for goods
and services. It is one of the key functions and characteristics of money,
ensuring smooth transactions in an economy.
 2. Durability:
Money must withstand physical wear and tear or remain functional in digital
formats over time.
3. Portability:
It should be easy to transport or transfer (e.g., cash or electronic transfers)[1][7].
4. Divisibility:
Money can be divided into smaller units to accommodate transactions of
varying sizes (e.g., $1 can be split into cents)[7].
5. Recognizability:
Authenticity and value must be easily identifiable to avoid counterfeiting.
6. Stability:
Its value should remain relatively constant over time to prevent inflation or
deflation.
Types of Money
Money can take various forms:
1. Commodity Money:
Physical items with intrinsic value, such as gold or silver (e.g., gold coins)[4][2].
2. Fiat Money:
Government-issued currency without intrinsic value but declared legal tender
(e.g., US Dollar, Euro)[2].
3. Fiduciary Money:
Instruments like checks or promissory notes that rely on trust for payment[1].
4. Digital/Cryptocurrency:
Decentralized electronic money such as Bitcoin.
 5. Bank Money:
Balances held in checking accounts used for cashless payments (e.g., debit
cards).
Supply of Money
The money supply refers to the total amount of currency and liquid assets
circulating in an economy. It is measured using aggregates:
1. M0 (Monetary Base): Currency in circulation plus central bank reserves[3].
2. M1: Includes M0 plus demand deposits like checking accounts[3].
3. M2: Adds savings deposits, small-denomination time deposits, and retail
money market mutual funds to M1[3].
Example:
During economic downturns, central banks may increase the money supply by
lowering interest rates or purchasing government bonds to stimulate spending.
Examples
 A $10 bill is fiat money used for everyday transactions.
 Gold coins are commodity money with intrinsic value.
 Bitcoin is cryptocurrency used for digital transactions.
 The Federal Reserve uses M2 measures to assess liquidity in the U.S. economy.
Money's functions, characteristics, types, and supply are integral to modern
economies, ensuring efficient trade, savings, investment, and financial stability
 Demerit Description

Inflation Risk Subject to inflation due to potential over-issuance.

Limited Durability Easily damaged by water, fire, or wear and tear.

Counterfeiting Weak to counterfeiting despite security features.

Health Risks Can spread germs and diseases during transactions.

Can become worthless if demonetized by the

Demonetization Risk government.

Fluctuating Exchange Value can fluctuate significantly in foreign exchange

Rates markets.

Does not earn interest, leading to potential loss of value

Lack of Interest over time.

Restricted Acceptability Generally not accepted outside its country of issue.

Using the formula above, let’s look at an example where you have $5,000 and can
expect to earn 5% interest on that sum each year for the next two years. Assuming
the interest is only compounded annually, the future value of your $5,000 today can
be calculated as follows: FV = $5,000 x (1 + (5% / 1) ^ (1 x 2) = $5,512.50
To find the present value (PV) when you know the future value (F), interest rate i,
and number of compounding periods periods n=1 you use the present value
formula:
PV= FV/ (1+i) t x n
FV=5,512.50
i=5%=0.05
t=2 years
n=1
PV=25,512.50/(1+0.05)2 =$5000
If PV=5000 and FV=5512.5 and t= 2 n=1 what is i=interest rate
The interest rate (i ) is calculated using the formula:

( )
n ⋅t
i
FV =PV × 1+
n

Rearranging to solve for i :

(( ) )
1
FV
i=n × n ⋅t
−1
PV

Given:
 PV =5000

 FV =5512.5

 t =2 years
 n=1 (compounding once per year)
Substituting these values into the formula:

(( ) )
1
5512.5
i=1 × 1 ⋅2
−1 =0.05
5000

Thus, the interest rate (i ) is 5% per year.

 FV =PV ׿
Given:

 PV (Principal) = $1000

 i (Interest Rate) = 6% or 0.06

 n (Compounding Frequency) = 1 (compounded annually)

 t (Time in Years) = 5 years

We calculate the future value for each year and subtract the principal to
find the interest earned.

Year-by-Year Calculation:

Year Formula for FV FV ($) Interest Earned ($)

1 1000 ׿ 1060.00 60.00

2 1000 ׿ 1123.60 123.60

3 1000 ׿ 1192.02 192.02

4 1000 ׿ 1263.43 263.43

5 1000 ׿ 1340.10 340.10

FV =PV ׿.

 The interest earned is the difference between the future value and the
initial principal ($1000).
NPV
Suppose a company is considering investing in a new project that requires an initial
investment of $10,000. The project is expected to generate cash flows over the next
5 years as follows:
 Year 1: $2,000
 Year 2: $3,000
 Year 3: $4,000
 Year 4: $5,000
 Year 5: $6,000
The discount rate for this project is 8%.
Step-by-Step Calculation:
Calculate the Present Value (PV) of Each Cash Flow:

1. Calculate the Total Present Value (TPV) of All Cash Flows:

TPV =1,851.86+2,572.02+3,175.32+3,675.15+ 4,083.48=15,357.83

2. Calculate the Net Present Value (NPV):

NPV=TPV−Initial Investment =15,357.83−10,000=5,357.83

Conclusion:
The NPV of this investment is $5,357.83. Since the NPV is positive, the investment
is considered profitable and should be undertaken.
This example illustrates how NPV helps in evaluating investment opportunities by
considering the time value of money.
Year Cash Flow PV Calculation PV ($) (Discounted)
0 ($1000) - -
1 $300 300 (1+0.06)1= 283.02
2 $400 400 (1+0.06)2= 356.16
3 $500 500 (1+0.06)3 = 419.73
Total Sum of PVs: 283.02 + 356.16 + 419.73= 1058.91
NPV= 1058.91 - 1000 58.91
The analysis focuses on calculating the present value (PV) and future value (FV) of
a $1,000 investment over a 5-year period, using a discount rate of 6%.
The PV calculation shows the discounted value of the $1,000 investment over
the 5-year period.
The formula for PV is: PV=FV (1+i) n
PV is the present value
FV is the future value (in this case, $1,000)
i is the discount rate (6% or 0.06)
n is the number of years
The PV values for each year are:
Year 1: PV=1000(1+0.06)1=943.40
Year 2: PV=1000(1+0.06)2=890.00
Year 3: PV=1000(1+0.06)3=839.62
Year 4: PV=1000(1+0.06)4=791.61
Year 5: PV=1000(1+0.06)5=747.26
 The total PV of the investment is $4,211.90.
The FV calculation shows the future value of the $1,000 investment over the 5-
year period, assuming a 6% annual growth rate.
The formula for FV is: FV=PV×(1+r)n
Where:
FV is the future value
PV is the present value ($1,000)
i is the growth rate (6% or 0.06)
n is the number of years
The FV values for each year are:
Year 1: FV=1000×(1+0.06)1=1060.00
Year 2: FV=1000×(1+0.06)2=1123.60
Year 3: FV=1000×(1+0.06)3=1191.02
Year 4: FV=1000×(1+0.06)4=1263.03
Year 5: FV=1000×(1+0.06)5=1338.23
If initial investment is $5000, n=5 and discount rate=i=6 % calculate the back
period, ARR, NPV and IRR and NCF are 700, 700, 800, 1800, 1500, 2200
To calculate the payback period, ARR (Average Rate of Return), NPV (Net
Present Value), and considering the Net Cash Flows (NCF) provided, we'll
proceed as follows:
1. Payback Period
The payback period is the time it takes to recover the initial investment.

Formula:
  Initial Investment = $5,000
 NCFs = $700, $700, $800, $1,800, $1,500
Year NCF ($) Cumulative NCF ($)
0 -$5,000 -$5,000
1 700 -$4,300
2 700 -$3,600
3 800 -$2,800
4 1,800 -$1,000
5 1,500 $500

2. Average Rate of Return (ARR)

ARR is the average return on investment over its life.

700+700+800+1,800+ 1,500 5,500

Average Annual Profit = 5
=
5
=1,100

3. Net Present Value (NPV)

NPV is the present value of all future cash flows minus the initial investment.

i = 6% = 0.06
n = 5 years and are NCFs = $700, $700, $800, $1,800 and $1,500
Year NCF Discount Factor Present Value
1 700 1.06 661.32
2 700 1.1236 622.22
3 800 1.191016 671.19
4 1,800 1.2630256 1,425.51
5 1,500 1.338225576 1,119.51
NPV = -5,000 + (661.32 + 622.22 + 671.19 + 1,425.51 + 1,119.51)
NPV = -5,000 + 4,499.75 = -500.25
Summary:
 Payback Period: 4.67 years
 ARR: 22%
 NPV: -$500.25 at a 6% discount rate
 IRR: Requires calculation or software to determine the exact rate.
Calculations Summary Table
Metric Calculation/Value
Payback Period 4.67 years
Average Rate of Return 22%
Net Present Value (NPV) -$500.25 at 6%

NPV Calculation Details

Year NCF ($) Discount Factor Present Value ($)
1 700 1.06 661.32
2 700 1.1236 622.22
3 800 1.191016 671.19
4 1,800 1.2630256 1,425.51
5 1,500 1.338225576 1,119.51