Purchasing Power of the Dollar

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(Image: One Dollar - variations of Crumpled dollar image by PaulPaladin from Fotolia.com)

The purchasing power of the dollar affects the price at which goods and services are sold, the minimum wage and a person’s ability to retire. In essence, the dollar’s value affects all U.S. consumers as well as many foreign governments and investors.

Definition of Purchasing Power

Purchasing power is the dollar’s value in terms of the quantity of goods and services it can purchase, Harvard economics professor Gregory Mankiw explains in his textbook, “Principles of Economics." Thus, if a person could buy two loaves of bread for a dollar a year ago but can only purchase one loaf of bread for a dollar today, the purchasing power of a dollar has decreased.

Types

The purchasing power of the dollar relates to foreign investment and international commerce as well. The term “purchasing power parity” refers to the discrepancy in one currency’s value compared to another. For example, if one euro buys two jars of peanut butter but a dollar buys one jar, the euro has greater purchasing power parity. In other words, the euro is stronger than the dollar.

Investors analyze the purchasing power of the dollar to determine if the currency is appreciating or depreciating in value. If the dollar appreciates, the U.S. imports more goods but exports less because now goods produced in America are more expensive overseas. Like stocks, if the strength of the dollar is high, investors may be tempted to buy more to buffer their portfolio, or they may sell dollars and collect a return.

History

Throughout the 20th century and into the present, other nations have regarded the dollar as a safe investment. The relative safety of the dollar is one reason it is considered the world reserve currency. After World War II, European countries borrowed dollars for reconstruction. The dollar’s strong purchasing power served as a stabilizing force in their unstable economies.

The dollar’s stable purchasing power also compels some countries to link or peg their currency to the dollar. Examples include Jordan, Barbados, Belize and the Maldives.

Significance

The purchasing power of the dollar affects the minimum wage and a person’s ability to retire. Because over time a dollar purchases fewer goods and services due to inflation, Congress has the power to adjust the minimum wage to reflect the decline in the dollar’s purchasing power.

A savings account interest rate tries to account for the natural decline in a dollar’s purchasing power. For example, a dollar will be worth considerably less in 50 years than its present value. Therefore, banks offer an interest-bearing savings account for retirees, investors and business owners.

Factors Affecting the Dollar

The amount of money in circulation affects the dollar’s purchasing power. If the money supply of dollars increases because the U.S. prints more money or a country sells its large holdings of the dollar on the market, the flush of dollars in circulation causes the currency to be worth less.

Paul Krugman and Robin Wells explain in the textbook, “Economics,” that the money supply also increases or decreases based on the interest rate set by the Federal Reserve. If the interest rate is high, borrowing money is discouraged and the money supply contracts. In turn, this contraction increases the purchasing power of the dollar.

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