Banking & Monetary Policy

The most important negative effects of inflation arise from reduction in purchasing power. Inflation can reduce the value of our money by a huge amount, making it even more difficult to purchase the things we want and need. Knowing how inflationary prices affect our purchasing power is an aspect of financial knowledge, and this skill will help us perform better in managing our money.
An influx of money into the economy from the macroeconomic point of view leads to inflation. Since there will be more money, it reduces the value of each and every unit of currency. This in turn increases the prices of the commodities and services by the reduced value of the money. Therefore, the money can purchase fewer goods and services than it could in the past.

Inflation and purchasing power-At the level of the individual, experiences vary from one person to another with the variables like income, expenses, and lifestyle.

Here’s how inflation may affect your purchasing power:

1. Savings: Because of time, inflation can gradually reduce the value of your savings. For example, imagine having $1,000 worth of savings, and the inflation rate is 3%. After one year, the value of your savings will have shrunk to $970.

2. It is more expensive to maintain living standards due to higher costs of living: With rising prices of goods and services, it becomes harder to achieve the same standard of living, thus reducing the quality of life.

3. Low returns: Inflation will also affect the return on investment. Let’s assume you invest in a bond yielding 2%, and you have a rate of inflation of 3%. This means you are losing money on your investment.

Understanding how inflation affects the purchasing power is extremely important in financial decision-making. In other words, having an understanding of inflation will enable people to think ahead and adjust their strategies because they will be able to realize early if the cost of living will continue to rise or not.