What Is Purchasing Power – Explain Like I’m Five

Written by Olly Milicich in Uncategorized

TL:DR – Purchasing power means how much stuff your money can buy. If prices go up, your money can’t buy as much. When prices rise, it’s called inflation, and it makes your money worth less. That’s why $5 today buys less than it did years ago.

What is Purchasing Power?

Purchasing power is the ability of your money to buy goods and services. Imagine you have $50 in the year 2000, and it can buy you a pair of jeans. As prices increase over time, in the year 2024, a similar pair of jeans will now cost $100. This increase in cost for the same item, or reduction in what your money can buy, is a decrease in purchasing power.

Over time, the value of money doesn’t stay the same. Inflation (rising prices due to money printing) reduces the purchasing power of your money. As the cost of everyday items increases, your dollar buys less than it did before. Understanding purchasing power is key to managing your money wisely because it affects how much you can afford to buy.

Long-Term Drop In Purchasing Power

In the early 20th century, a U.S. dollar could buy many more things than it can today. Back then, $1 could cover a week of groceries or many household goods. But as years went by, that same dollar lost much of its purchasing power due to inflation, and now barely buys a pack of gum.

For example, 100 years ago, one ounce of gold could buy a high-quality custom-made suit. Today, even though the price of gold has risen from around $35 per ounce to over $2,500, that same ounce of gold still buys a suit of similar quality. This shows that while money loses purchasing power over time, gold maintains its value. Unlike the dollar, which has weakened, gold’s purchasing power has remained relatively stable.

What is Inflation?

Inflation is the general rise in prices over time due to the government creating more money. When inflation occurs, the money you have loses its ability to buy as much as it could before. For example, if inflation causes prices to increase by 5%, an item that cost $100 last year will now cost $105, meaning your $100 no longer buys as much as it once did.

Think of inflation like a pie. Each dollar is a slice of that pie. When the government prints more money, it can’t make the pie bigger, so it just cuts more slices. Each slice (dollar) becomes smaller, meaning prices go up, and your purchasing power shrinks.

How Gold Protects Purchasing Power

Gold is often considered a hedge against inflation, meaning it holds its value even as the dollar weakens. While the value of the dollar has gone down over time, gold has retained its purchasing power. For example, 100 years ago, an ounce of gold could buy a high-quality suit, and today, that same ounce of gold can still buy a similar suit, even though the price of gold has skyrocketed.

This happens because gold is finite—there’s only so much of it in the world, making it a scarce resource. In contrast, governments can print more money, which weakens the value of the currency. This is why many people invest in gold to protect their wealth from the effects of inflation. When the value of money falls, gold typically remains strong, preserving purchasing power.

Factors That Affect Purchasing Power

There are several reasons why purchasing power decreases:

  • Inflation: The main reason is inflation. When more money is printed and enters the economy, each dollar is worth less, and prices go up.
  • Demand-pull Inflation: This happens when more people want to buy things than there are items available. When demand exceeds supply, prices go up.
  • Cost-push Inflation: This occurs when companies have to pay more to make products. For example, if the cost of materials increases, companies raise prices to cover their costs, lowering purchasing power.
  • Interest Rates: When interest rates rise, it becomes more expensive to borrow money. This reduces how much people can spend, which can also reduce purchasing power in the economy.
  • Shrinkflation: Sometimes, companies keep prices the same but give you less product. For example, the price of a bag of chips might stay the same, but the bag contains fewer chips than before. This also reduces purchasing power, as you’re paying the same but getting less.

How Purchasing Power Affects Different People

Purchasing power affects everyone in different ways:

  • For Consumers: As prices rise, you need more money to buy the same items, making it harder to afford basic goods and services.
  • For Businesses: When inflation increases their costs, businesses have to raise prices to stay profitable. This can make their products less attractive to consumers, especially if people’s wages don’t rise as fast as inflation.
  • For Investors: Inflation can reduce the value of investment returns. For example, if inflation is 4% and your investment returns 5%, your real gain is only 1%. Investors need to account for inflation to protect their purchasing power.
  • For Retirees: People living on fixed incomes, like retirees, are hit hardest by inflation. As prices rise, their income buys less, reducing their ability to afford the things they need.

The Role of the Government

Governments play an important role in managing inflation and protecting purchasing power.

  • Inflation Control: Governments and central banks, like the Federal Reserve, adjust interest rates to control inflation. If inflation gets too high, they raise interest rates to make borrowing more expensive. This slows down spending and keeps prices from rising too quickly.
  • Digital Currencies: Some governments are considering creating digital currencies, like the digital dollar. This could make transactions easier but might also allow governments to print more money digitally, which could increase inflation and reduce purchasing power further.

Protecting Your Purchasing Power

There are ways to protect your purchasing power over time:

  • Investing in Gold: Gold is a classic way to preserve purchasing power because it holds its value even when the dollar loses value.
  • Other Investments: Investing in stocks, bonds, or real estate can also help protect against inflation. These investments often grow in value faster than inflation, helping you keep or even grow your purchasing power.

National and Global Economic Effects of Purchasing Power

When inflation rises too much, it doesn’t just affect individuals—it can slow the whole economy. People buy less because their money is worth less, and this can cause businesses to raise prices or cut back on production.

  • National Impact: Governments often raise interest rates to fight inflation. This makes borrowing money more expensive, which can reduce investments and slow job growth.
  • Global Impact: Inflation in one country can affect others. If one country experiences high inflation, it might charge more for the goods it exports, making it harder for other countries to afford those goods.
  • Currency Devaluation: If a country’s currency loses too much value, it makes trading with other countries more difficult. This can hurt both the local economy and the global market.
  • Debt Impact: Inflation can lower the real value of a country’s debt, but if inflation gets too high, borrowing money becomes very expensive. This forces governments to cut spending on important programs.

Conclusion: Why Purchasing Power Matters

Understanding purchasing power is important for everyone because it affects how much we can buy, how much our investments grow, and how we manage our money. Inflation is one of the biggest threats to purchasing power, but by learning how it works and how to protect against it, you can make better financial decisions for the future.

Reference Videos

https://www.youtube.com/watch?v=todNCggRU0Y
https://www.youtube.com/watch?v=vjlt3HPBfxQ
https://www.youtube.com/watch?v=iOxYbH5XyG8

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