Purchasing Power: The True Value of Money
The Core Idea: What Is Purchasing Power?
Imagine you have a $10 bill. Ten years ago, that bill could buy two large pizzas. Today, it might only buy one. The bill itself is still $10, but its purchasing power—its ability to buy goods—has decreased. This is the heart of the concept: purchasing power measures the "real" value of money, not just its face value.
Think of money as a tool. Its usefulness isn't in the paper or coins, but in what you can exchange it for. When purchasing power falls, each unit of currency (like a dollar or a euro) buys fewer items. When it rises, each unit buys more. This dynamic is directly linked to the general price level of things we buy every day.
Inflation: The Thief of Purchasing Power
The most common enemy of purchasing power is inflation. Inflation is a general and sustained increase in the prices of goods and services in an economy over a period of time. A little inflation is normal in a growing economy, but high inflation can rapidly destroy the value of money.
Let's use a simple example. Suppose you save $100 in a piggy bank. This year, that $100 could buy 20 notebooks at $5 each. If the inflation rate for notebooks is 10% per year, next year one notebook will cost $5.50. Your saved $100 will now only buy about 18 notebooks. Your money's purchasing power has been "inflated away." You didn't lose any dollars, but you lost real value.
| Year | Price of One Pizza | What $50 Can Buy (Quantity) | Purchasing Power of $50 in Pizza Terms |
|---|---|---|---|
| Year 1 | $10.00 | 5 pizzas | Full (100%) |
| Year 2 (4% Inflation) | $10.40 | ~4.8 pizzas | ~96% of Year 1 |
| Year 3 (4% Inflation) | $10.82 | ~4.6 pizzas | ~92% of Year 1 |
| Year 5 (4% Inflation Each Year) | $11.70 | ~4.27 pizzas | ~85% of Year 1 |
Measuring the Change: The Consumer Price Index (CPI)
How do we know if purchasing power is going up or down? Economists use a tool called the Consumer Price Index (CPI)[1]. The CPI tracks the average change over time in the prices paid by urban consumers for a market basket of consumer goods and services. This basket includes things like food, clothing, shelter, transportation, and medical care.
The process works like this:
- Experts determine a typical basket of goods and services that an average household buys.
- They track the total cost of that basket over time.
- They set the cost in a base year equal to 100.
- If the same basket costs $110 a year later, the CPI is 110, indicating a 10% increase in the price level.
The inflation rate is often calculated as the percentage change in the CPI from one period to another. A rising CPI means average prices are rising, so the purchasing power of money is falling.
Purchasing Power in Your Daily Life: Wages and Savings
Purchasing power isn't just about prices; it's also about your income. What matters is your real income, not your nominal income.
- Nominal Wage/Income: The amount of money you earn in current dollars. For example, a $50,000 salary.
- Real Wage/Income: Your nominal income adjusted for inflation. It measures how many goods and services your income can buy.
If you get a 5% raise (nominal) but inflation is 7%, your real income has actually decreased. Your purchasing power has gone down, even though you have more dollars in your paycheck.
For savings, the concept is crucial. Keeping cash under your mattress is a guaranteed way to lose purchasing power over time due to inflation. This is why people invest in assets like stocks, bonds, or real estate—they hope these investments will grow at a rate higher than inflation, thus preserving or increasing their real wealth.
A Global Perspective: Purchasing Power Parity (PPP)
Purchasing power also lets us compare economies around the world. Purchasing Power Parity (PPP)[2] is a theory that says in the long run, exchange rates should adjust so that an identical product (like a Big Mac) costs the same in different countries when priced in a common currency.
For example, if a phone costs $500 in the U.S. and ¥30,000 in Japan, PPP suggests the exchange rate should be $1 = ¥60 (30000 / 500). If the actual exchange rate is $1 = ¥100, then the yen is considered undervalued according to PPP. This concept helps economists compare the standard of living and economic output between nations more accurately than using market exchange rates alone.
A Practical Case: The Shrinking Candy Bar
Let's follow a concrete, real-world example. Many companies face a choice during inflationary periods: raise the price of their product or reduce its quantity/quality. This is sometimes called "shrinkflation."
Imagine your favorite chocolate bar has cost $1.00 for years. The company's costs for cocoa and sugar rise by 20%. To keep the price at $1.00 and not scare customers with a price hike, they reduce the bar's weight from 100 grams to 85 grams.
The result? Your $1.00 has lost purchasing power. You are getting 15% less chocolate for the same money. The nominal price is stable, but the real price per gram has increased. This is a hidden form of inflation that directly attacks your purchasing power. It shows why you must pay attention to both price and quantity when assessing value.
Important Questions
Q: If my allowance stays the same for three years, but prices go up, what happens to my purchasing power?
It decreases. Even though you receive the same number of dollars, each dollar can now buy less than it could before. You would need a raise in your allowance just to keep up with rising prices and maintain the same level of purchasing power.
Q: Can purchasing power ever increase?
Yes, during periods of deflation, which is a general decrease in the price level. If prices fall, the same amount of money can buy more goods and services, so purchasing power increases. However, sustained deflation is rare and can be a sign of serious economic problems, like a deep recession, because people may delay spending hoping prices will fall further.
Q: How can I protect my personal purchasing power?
You can protect it by making your money grow at a rate that equals or exceeds inflation. This typically means not just saving cash, but investing in assets that have the potential to appreciate in value. Examples include putting money in a high-yield savings account (though often this just lessens the loss), buying stocks or bonds through funds, or investing in your own education to earn a higher real income in the future.
Footnote
[1] CPI (Consumer Price Index): A measure that examines the weighted average of prices of a basket of consumer goods and services, such as transportation, food, and medical care. It is calculated by taking price changes for each item in the predetermined basket and averaging them. The CPI is one of the most frequently used statistics for identifying periods of inflation or deflation.
[2] PPP (Purchasing Power Parity): An economic theory that compares different countries' currencies through a "basket of goods" approach. According to PPP, two currencies are in equilibrium when a basket of goods is priced the same in both countries, taking into account the exchange rates.