Chapter 10: Problem 317

What happens to the purchasing power of money when there is inflation? What does it mean?

Short Answer

Expert verified

When there is inflation, the purchasing power of money decreases because the general level of prices for goods and services is rising. This means that one unit of currency can buy less than before, making it less valuable. For example, with a 2% annual inflation rate, the same goods and services that cost \(100 today would cost \)102 next year, reducing the purchasing power of the initial \(100. This relationship emphasizes the importance of understanding inflation and its impact on the economy and individual financial decisions.

Step by step solution

1. Define Inflation and Purchasing Power

Inflation is the rate at which the general level of prices for goods and services is rising, and subsequently, the purchasing power of currency is falling. Purchasing power is the value of money, measured by the quantity and quality of goods and services it can buy.

2. Explain the Connection between Inflation and Purchasing Power

The connection between inflation and purchasing power lies in the fact that when prices of goods and services increase due to inflation, one unit of currency can buy less than before. As a result, the purchasing power of money decreases, making it less valuable.

3. Illustrate the Effect of Inflation on Purchasing Power

Assume that the inflation rate is 2% per year. This means that the general level of prices for goods and services increases by 2% each year. If you have \(100 today, you can buy a certain amount of goods and services. However, next year, due to a 2% increase in prices, the same goods and services that you could buy with \)100 today would cost you \(102. As a result, the purchasing power of your \)100 would decrease, as it can buy fewer goods and services.

4. Understand the Meaning of the Relationship between Inflation and Purchasing Power

In conclusion, when there is inflation, the purchasing power of money decreases because the general level of prices for goods and services is rising. This means that, as inflation continues, people need more money to buy the same amount of goods and services as before. It highlights the importance of understanding inflation and its consequences on the economy and individual financial decisions.

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