Purchasing Power and Inflation: Understanding Your Money’s Value

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Inflation is on the rise, and everyone is feeling it. From groceries to vacations, everything costs more. But what causes inflation and what does it mean for your financial situation? The reason behind inflation is purchasing power, and the value of money — it’s not how much things cost per se, it’s how much you can buy.

Here’s what you need to know.

Key Takeaways

• Purchasing power is the amount of goods your money will buy.
• It’s usually expressed as the amount one unit of currency can buy, so, “the purchasing power of a dollar.” It’s sometimes referred to as buying power.
• Inflation and wages both influence purchasing power. Inflation reduces purchasing power by making goods more expensive.
• The government measures inflation by the Consumer Price Index.

With inflation on the rise, it’s easy to see how it impacts purchasing power. If you spend $100 at the grocery store today, you’re probably carrying home fewer bags than you did when you spent $100 a few years ago. Because of inflation, your purchasing power has decreased.

What Factors Affect Purchasing Power?

Purchasing power is affected by both inflation and wages, and how they move relative to one another.

• When inflation rises, purchasing power falls, assuming wages remain the same.
• In times of deflation, when prices are falling, purchasing power increases, as long as wages remain the same.

Wages are the other side of the purchasing power coin.

• If wages increase and prices remain the same, workers can buy more goods, so purchasing power increases.
• If wages fall and prices remain the same, purchasing power declines, because workers are making less money.

The Consumer Price Index and Inflation

Inflation is measured by the change in the CPI. The Consumer Price Index represents a basket of goods and services that consumers buy. There are actually several indexes:

• Those that include only food
• Those that include food, housing and energy
• Those for different demographic areas, like urban and rural areas.

The idea behind the CPI is to measure the change in the cost of these goods and services so that the government can take steps to mitigate price increases on consumers.

Wages and Purchasing Power

Wages are the other factor that influences purchasing power.

• If the amount of money you earn goes up at the same rate as the cost of the goods you buy, your purchasing power remains the same.
• If inflation is higher than the increase in wages, purchasing power goes down.
• If your income rises faster than inflation, your purchasing power rises.

Don’t be confused by the term wage inflation. Generally, when people talk about inflation, they mean price inflation. This type of inflation causes you to be able to buy fewer goods for the same amount of money. Wage inflation is when wages rise, so workers earn more money. Assuming that prices remain stable, workers can buy more, because they have more money. So wage inflation benefits consumers, but price inflation does not.

Here’s an example. In the 1960s, a family might have had an annual income of $5,600. This seems impossible until you realize that that 1960s family could buy a house for about $11,900, about twice their annual income. Today, a family might have an annual income of $68,700. The average price of a home is about $240,000, about three and a half times the family’s annual income. Purchasing power today is less than it was in the 1960s.

Controlling Purchasing Power

The two components of purchasing power — wages and prices — are dictated by the market in a free market economy — in theory, at least. Employers pay workers the amount that the workers are willing to work for. Consumers buy goods at the price they are willing to pay.

This works fine until there is an imbalance in the number of available workers or the amount of available goods. These conditions can cause wages and prices to rise or fall, changing purchasing power.

Sometimes the government needs to step in to balance out purchasing power so that necessary goods are available at a price people can afford to pay. The government may raise or lower interest rates in an attempt to make credit more or less expensive. When interest rates rise, people spend less, which causes prices to fall. Raising taxes can have the same effect of dampening demand which lowers prices.

The government can also step in to impact wages, by increasing the minimum wage. This can be an inefficient approach, however, since states can also set their own minimum wage — as long as it is at least as much as the federal minimum wage. This also doesn’t affect workers in the private sector who already make more than the minimum wage. Higher wages can also be inflationary, as higher wages mean more purchasing power, increasing demand and driving prices up.

How To Deal With Declining Purchasing Power: 3 Tips

If you feel like you’re getting less for your money these days, you’re right. So, what can you do about it? There are a few things that will help.

1. Don’t Use Credit

If you carry a balance on your credit card, stop. Pay off as much of your debt as you can, and then only charge what you know you can pay off at the end of the month. Not paying interest is an easy way to put more money in your pocket.

2. Eliminate Unnecessary Expenses

Cutting out subscriptions you don’t use and eating at home instead of going out are good ways to pare down your expenses. And these types of discretionary purchases are the ones that usually go up in price the fastest.

3. Increase Your Income

If you’re already sticking to an austere budget, maybe the answer is to bring in more income. Take a part-time job or start a side hustle to bring in some extra cash so you can stay ahead of rising prices.

Final Take

Purchasing power ebbs and flows with normal economic cycles. But now that you understand what affects it and what you can do about it, you’re in a better place to manage a temporary decline in purchasing power.

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