# inflation rate vs interest rate on calculating present value of future money

i use the formula 100/(1+r)^T to calculate the present value of my future money while r is interest rate and T is year.

However , for my country , interest rate (year) = %8.25 and inflation rate (year) = %12.60

Is it logical if i use inflation rate instead of interest rate at my calculation?

• It would make more sense to use real interest rate - if we are talking about money in some interest bearing account
– 1muflon1
Jul 25 '20 at 19:29
• @1muflon1 i edited the question. can you comment this version? Jul 25 '20 at 20:00
• You can choose whatever you want for your own analysis. Interest rates are typically used as they represent the cost of financing something, or for comparing investment value versus bonds. You cannot directly purchase the CPI, so its change is of interest, but not an investment alternative. Jul 25 '20 at 20:03
• The same comment stands - if you are for example contemplating some problem like someone offers you 100USD now vs 150USD next year you should use real interest rate to calculate the present val. of 150USD because not only in the first scenario you get the money now before they become less valuable due to inflation but at the same time you can put them to some account that will bear interest hence you should take into account both nominal interest rate and inflation which is done by using real interest rate
– 1muflon1
Jul 25 '20 at 20:09
• @1muflon1 yes. let me calculate real interest rate is 8.25 - 12.60 = - %4.35 . Even i bear the interest of my present money , it will not be compansated from the effect of inflation. So is it more precise to calculate present value with inflation rate instead of interest rate? Jul 25 '20 at 20:23

The correct rate for present value calculations is the discount rate.

The inflation rate is inferior because it does not allow for other considerations such as risk.

A quoted "interest rate" is context dependent so it cannot be evaluated by the magnitude of the rate alone. Which person or organization is quoting the rate? Is it wise to rely upon the quote? If it is a person, is this person willing and able to repay a loan? Is it a bank? Are deposits at that bank protected by an insurance plan? Does a government control the insurance company? Has the government created the conditions for reliable deposit insurance?

The most appropriate discount rate is not a quote from another person or organization. The discount rate must be particular to the contemplated investment and your circumstances. One way to arrive at a discount rate is to consider the following...

  discount rate =
expected inflation rate +
expected real growth rate of the economy +
uncertainty factor +
other

expected real growth rate of the economy =
expected nominal growth rate of the economy -
expected inflation rate


The uncertainty factor is also called the risk premium. Since the expected inflation rate is added in one equation but subtracted in the other equation, a simplification is possible.

If you are contemplating a bank deposit you might wonder why it is necessary to consider the growth of the economy. If you control your investments, you might consider investing in a business. Attractive alternatives increase your required return for a bank deposit. If this alternative is unlikely or impossible, then economic growth is a less important factor, however, it never disappears completely because the bank's health is economically dependent.

The question has some ambiguity. If you want to calculate something, you need to define what you are interested in. If you want to think in terms of purchasing power, you can use the inflation rate.

However, using inflation would be the wrong answer in the context of finance or project analysis. In the financial context, you are comparing money now versus money in the future. The basis of comparison is an instrument that bridges money from the present to the future, which are debt instruments.

For example, if you are borrowing to finance a project, your profitability depends on the return of the project in nominal terms versus the cost of financing. What the value of the currency does versus a basket of goods during that time does not matter.

The idea of inflation trading off future returns is a beloved concept of conventional economists, but its usefulness is greatly overrated. Since you cannot purchase the CPI basket and store it indefinitely, there is no obvious necessary relationship between inflation rates and the return on investable assets. (People might invoke model relationships, but that puts a lot of faith in the models.)

To me makes more sense to use the real interest rate, that is the nominal interest rate adjusted for inflation. Because you have to use a discount rate to calculate the present value of money, so I suggest you to use the interest rate adjusted for inflation (that is the nominal interest rate minus the inflation rate) and not the inflation rate per se (since it doesn't tell you the return on your project, but tell you only the purchasing power of the money and you don't want to know that but you want to know the real rate of return on your project, i.e. the nominal rate minus the inflation rate). So, using only the inflation rate is not useful. Instead you should use the inflation rate with regard to the nominal interest rate, in a way that you can calculate the real interest rate that you use to calculate the time value of money