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What’s it: The purchasing power of money is a currency’s ability to convert it to goods and services. In other words, it is the
The purchasing power of money is an essential indicator in making decisions. If purchasing power goes down, you get less product for using the same amount of money as before. Conversely, if the purchasing power goes up, you get more products.
Calculating the purchasing power of money (with examples)
Calculating the purchasing power of money is relatively easy. You simply divide the quantity you get by the price you pay.
Let’s take a simple example. Two years ago, you bought shoes and paid $100. Now you visit the same shop to buy these shoes. The price of the shoes actually increased to $200. In this case, your purchasing power drops from 1/100 to 1/200.
Take another example. A company buys 1 tonne of cement for $40 per tonne. Furthermore, the following year, the company purchased 1 tonne of cement for $50. In this case, we see the purchasing power of company money dropping from 0.25 (1/40) to 0.2 (1/50).
Factors affecting the purchasing power of money
The purchasing power of money (PPM) is like a built-in
Think of price level as the average price tag across all goods and services in an economy. When this average price tag goes up, it means things are generally getting more expensive. Here’s the connection to PPM:
Higher price level = Lower purchasing power: As the average price of goods and services (price level) increases, your money buys less. Imagine you have $100 today. If the price of everything you typically buy goes up, that same $100 won’t get you as much stuff anymore. Your purchasing power has decreased.
The term for this ongoing increase in the price level is inflation. Inflation erodes your money’s purchasing power over time. A dollar today won’t buy the same things ten years from now because of inflation. This is why concepts like “keeping up with the cost of living” are so important – rising prices mean you need to earn more just to maintain your current standard of living.
Explaining inflation’s impact on the purchasing power of money
As in the previous example, purchasing power negatively correlates with price. When the price goes up, the money’s purchasing power falls. And vice versa, when prices fall, purchasing power increases.
In aggregate, the inflation rate is the indicator of price increases. So, in conclusion, inflation reduces the purchasing power of money. We can get the inflation rate from changes over time in several price indexes, such as the Producer Price Index, the Consumer Price Index, and the Wholesale Price Index. For overall goods and services in the economy, we use the GDP deflator because it is more representative than those price indexes.
One simple way to think about purchasing power is to imagine your salary was the same as your father’s 20 years ago. How much are you getting with that money now?
Yes, you will get less. This happens because inflation (the increase in the price of goods) continues to undermine money’s purchasing power.
If inflation is relatively low and stable, the decline in money’s purchasing power may not be significant. However, if inflation suddenly spikes, money’s purchasing power quickly evaporates.
We call hyperinflation a condition in which inflation is so high. It is one threat that often destroys economies. When hyperinflation occurs, the price level can increase by 1,000,000% in one year, as happened in Venezuela in 2018. Such conditions can lead the economy to crisis, not only economic but also humanitarian. The number of poor people has skyrocketed, and that may lead to social unrest and crime.
Hyperinflation occurs because the money supply increases drastically and is not followed by the economy’s number of goods and services. One reason is that governments overprint money, perhaps to pay off debts or for war. As a result, more money goes after less stuff.
Consequences of changing purchasing power of money
When purchasing power (PPM) weakens, it triggers a chain reaction across the entire economy, impacting businesses, households, investors, and financial markets. Here’s a closer look at how different sectors feel the pinch:
Businesses under pressure
Companies grapple with increased production costs. As the price of raw materials and labor goes up due to inflation, businesses have to spend more to produce the same goods. This can squeeze their profit margins or force them to raise prices, further impacting consumers.
Imagine a bakery facing rising flour and sugar costs. To maintain profitability, they might have to raise bread prices, putting additional strain on household budgets. In a worst-case scenario, businesses may struggle to stay afloat, leading to layoffs and a weakened job market. This ripples through the economy, reducing overall tax revenue for the government and potentially leading to cuts in public services.
Household headaches
For everyday people, declining PPM translates to a higher cost of living. The same groceries, utilities, and other expenses become more expensive, forcing households to tighten their belts. This can lead to reduced consumption, impacting overall economic growth.
Think about groceries costing 10% more this year compared to last. Families might have to cut back on other expenses or entertainment to make ends meet. Over time, this decline in purchasing power can erode savings and retirement nest eggs, impacting long-term financial security.
Imagine a young couple saving for a down payment on a house. With rising housing costs and everyday expenses eating away at their savings, their dream of homeownership becomes increasingly distant. This can lead to feelings of frustration and social discontent.
Investor uncertainty
Investors face the challenge of misleading company financials. Inflation can distort reported revenue and profit figures. Companies experiencing high revenue growth might not necessarily be selling more products – it could simply be due to inflated prices.
Similarly, inflated inventory costs due to rising raw material prices can make profits appear higher than they actually are using specific accounting methods. This makes it harder for investors to accurately assess a company’s performance and make informed investment decisions.
In some cases, investors might pull their money out of the market due to uncertainty, leading to market downturns. This can discourage business investment as well, hindering economic growth and innovation.
Financial market fluctuations
Declining PPM also affects the discounted value of securities. Imagine a bond promising a fixed interest rate of 5% in the future. If inflation is steadily at 7%, the actual purchasing power of that 5% return gets eroded.
Investors become more cautious, demanding higher returns on their investments to compensate for inflation. This can lead to higher interest rates, making borrowing more expensive for businesses and consumers alike.
The combination of higher interest rates and market volatility can discourage investment and hinder economic growth. Pension funds and other long-term investors heavily reliant on fixed-income securities can see their portfolios shrink, impacting retirees and institutions that depend on those returns.
In essence, declining purchasing power creates a domino effect. Businesses struggle with rising costs and potentially lower sales, consumers cut back on spending, and financial markets become jittery. This can lead to a stagnant or even shrinking economy, unemployment, and social unrest. This is why maintaining stable inflation is crucial for a healthy and predictable economic environment.
Central banks play a vital role in managing inflation through monetary policy tools like interest rates and reserve requirements to ensure price stability and protect the purchasing power of money. By keeping inflation under control, central banks help create an environment where businesses can invest and grow, consumers can plan for the future, and financial markets function smoothly – all essential ingredients for a thriving economy.
Government policies to maintain the purchasing power of money
We now understand that inflation, the sustained increase in price levels, is the arch-villain behind declining purchasing power. So, what can governments do to combat inflation and protect the value of your money?
They primarily rely on a set of tools called contractionary economic policies. These policies aim to reduce aggregate demand, the total amount of spending in the economy. Less demand for goods and services, in theory, should lead to price stability or even deflation (falling prices). Here are some key contractionary measures:
- Trimming government spending: By cutting back on unnecessary expenditures, the government injects less money into the economy. This reduces overall demand and puts downward pressure on prices. Imagine the government scaling back on public works projects. This frees up money, but it also reduces demand for construction materials and labor, potentially slowing price increases in those sectors.
- Tax time: Raising taxes takes money directly out of consumers’ pockets, reducing their purchasing power. This decrease in demand can help cool down inflation. However, governments need to strike a balance – excessively high taxes can stifle economic growth.
- Interest rate hikes: Central banks, the institutions that manage a country’s money supply, can raise interest rates. This makes borrowing more expensive for businesses and consumers, encouraging them to save more and spend less. Think of a business owner considering a loan to expand. With higher interest rates, the loan becomes more costly, potentially leading them to postpone expansion plans, reducing overall demand for goods and services.
- Selling government bonds: Through open market operations, central banks can sell government bonds to investors. This absorbs money from circulation, effectively tightening the money supply. With less money floating around, inflation can be brought under control.
When supply shrinks
These contractionary policies work well when inflation stems from excessive demand. However, a more complex situation arises when inflation is caused by a decrease in aggregate supply. This could be due to factors like natural disasters, supply chain disruptions, or limited resource availability.
In such cases, reducing demand through contractionary policies might not be enough. The government might need to consider alternative solutions, like increasing domestic production or facilitating imports, to address the supply shortage directly.
In conclusion, governments have a range of tools at their disposal to combat inflation and protect purchasing power. However, the effectiveness of these tools depends on the root cause of inflation.
