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The Cost of Money

You may have noticed that the price of gasoline has gone up. What if you took a dollar and bought some gasoline today: how much could you buy—half a gallon, a quarter gallon? If gasoline were to cost $2.00 a gallon, you would be able to buy only half a gallon of gasoline. But what if you took that dollar and, instead of buying gasoline, buried it in a coffee can under a tree for a year and then dug it up—how much gasoline could you buy then? We really do not know the answer to that question, but let's look at the scenario going backward. According to the US Bureau of Labor Statistics, the price of that same gallon of gasoline cost about $0.65 this same time just over 25 years ago, which means that a dollar back then would have purchased over 1½ gallons of gasoline. The same dollar purchased about three times as much gasoline 25 years ago as it does today.

Interest is the compensation for the loss of value of money over time.

Since the gasoline of which we speak is not the new and improved variety that gets you further per gallon, the only conclusion we can draw is that the dollar somehow became worth less today than it was then. Of course, you recognize this phenomenon as inflation. Inflation is the tendency for prices of goods and services to increase over time. Inflation affects all our goods and services, not just gasoline. Economists have many theories as to why this phenomenon occurs, but suffice it to say that regardless of the reason, it does seem that a dollar today is worth more than a dollar tomorrow.

This brings us to the point that there is a cost of money—sometimes referred to as the time value of money. Instead of burying your dollar in a coffee can, you lend it to a friend for a year. When you get it back, you will not be able to buy the same amount of goods or services you would have been able to buy had you spent it instead, yet your friend did enjoy the full value of your dollar. You should be compensated for the loss of value, right? Interest is the compensation for the loss of value of money over time—it is the cost of money. Interest may be tied to inflation, but it may also have a risk component, or "risk premium." A risk premium is an extra charge added to inflation to make up for the potential loss of value due to default, and is part of interest.