The demand for money is affected by several factors, including the level of income, interest rates, and inflation as well as uncertainty about the future. The way in which these factors affect money demand is usually explained in terms of the three motives for demanding money: the transactions, the precautionary, and the speculative motives.

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 conversion rate of money towards goods and services. Another term for the purchasing power of money is the real value of money.

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 plus an example

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).

What factors influence the purchasing power of money

As in the two examples above, the primary determinant of money’s purchasing power is the price. It decreases with increasing prices. And, at the aggregate level, we use the term price level to represent the average price of all goods and services. The increase in the price level is called inflation.

The effect of inflation 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 indicator of price increases is the inflation rate. 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. And, for overall goods and services in the economy, we use the GDP deflator because it is more representative than those price index.

One of the ways to think about purchasing power is simple. Imagine your salary was the same as your father’s salary 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 high, the purchasing power of money quickly evaporates.

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The condition in which inflation is so high we call hyperinflation. 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 a humanitarian crisis. The number of poor people has skyrocketed, and that may lead to social unrest and crime.

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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.

The impact of changes in the purchasing power of money

Purchasing power affects many aspects of the economy, from household consumption to business investment to overall economic prosperity. When the purchasing power of money falls, serious negative economic consequences arise, including:

  • Increasing the costs of producing goods and services. Companies have to spend more to buy raw materials and pay workers.
  • Increase in the cost of living. Households have to spend more than before to get the same item. To compensate for this increase, consumers must get a higher income. And, of course, it’s not that easy.
  • Interest rate hikes. The central bank will usually raise interest rates to avoid severe inflation. An increase in interest rates increases the payment of interest and principal on debt.

Misleading company revenue figures

Say, a company reports high revenue growth rates. At the same time, inflation has also shot up.

Just by looking at this growth, you may draw misleading conclusions.

As we know, revenue is the function of volume and selling price. In this case, inflation spiked. Therefore, before making any conclusions, you should observe whether the revenue growth is due to increased selling prices or sales volume.

Ideally, high revenue growth will come from an increase in sales volume because it shows its success in marketing its products.

Inflation can also mislead company-reported profit figures. One source of the problem is the inventory accounting method used by the company. When inflation is soaring (the price of goods is rising), firms may be tempted to use the fist-in, first-out (FIFO) inventory method. FIFO delivers a lower cost of goods sold figures than the last-in, first-out (LIFO) method. Thus, profits artificially increase.

Effects on financial markets

The purchasing power of money also affects the discount value of securities. When inflation rises, future dividends or interest payments will be worthless.

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Long story short, the higher the inflation, the higher the discount rate, and the lower the securities’ value.

Government policy to keep the purchasing power of money

The source of the decline in purchasing power comes from the inflation rate. During high inflation, the government should adopt a contractionary economic policy (through monetary policy or fiscal policy) to reduce it. Among the options are:

  • Reducing government spending
  • Raising taxes
  • Lifting the policy interest rate
  • Raising the reserve requirement ratio
  • Open market operations by selling government securities

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Those options cause aggregate demand in the economy to weaken. Weakening aggregate demand slows down the rate of increase in the price level.

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A policy dilemma occurs when the source of inflation comes from a decrease in aggregate supply. Both policies are ineffective because they only affect aggregate demand.