What Effect Does Inflation Have on the Purchasing Power of a Dollar?

"Purchasing power" refers to the amount of goods and services that can be purchased with a given amount of currency. The price level of goods and services in the economy determines the purchasing power of the currency. As the country experiences inflation over time, the purchasing power of the dollar falls.

A unit of currency has no intrinsic value. You cannot use a dollar for anything useful, apart from using it to buy other things you need. Therefore, the value of a dollar is completely dependent upon what you can buy with it. If you can buy an ice cream cone for a dollar, the purchasing power of a dollar could be said to be equal to one ice cream cone. If the economy experiences inflation, however, the price of the ice cream cone might increase to $1.10. In this case the purchasing power of a dollar would be less than one ice cream cone.

Inflation erodes the purchasing power of the dollar. If you have $10,000 today, but there is 10 percent inflation over the next year, your money will buy 10 percent less than it could have at the beginning of the year. In other words, at the end of the year the purchasing power of your $10,000 will have fallen to $9,000. People often invest money or save money in interest-bearing accounts to mitigate the effects of inflation. For instance, if inflation is 5 percent, but you put your money in a savings account that pays 6 percent interest, the purchasing power of your savings will increase by 1 percent.

The effect of inflation on purchasing power can be beneficial in some circumstances. For instance, if you have outstanding debts, inflation will reduce the effective cost of the debt. Income levels tend to increase along with increases in inflation. For instance, if inflation is 4 percent and your income rises by 6 percent, your real income -- your income subtracting the effects of inflation -- has increased despite the fact that each dollar you earn is worth less.

Inflation has the potential to destroy wealth over time. Let's say you have $100,000 and you decide to bury it in the ground so that you aren't tempted to spend it. If the economy experiences 10 percent inflation every year and you dig the money up 10 years later, the purchasing power of the money would be less than half of its original value.

Since inflation erodes the purchasing power of money, invest or save your money to preserve the wealth. Government bonds and government-insured certificate of deposit accounts are low-risk ways to earn interest on money to fight the effects of inflation.