Different economic issues factor into the increase and decrease of the purchasing power of a dollar. These reasons can include a rise or fall in the Consumer Price Index or CPI, inflation, economic growth or economic recession. The effect of purchasing power changes has an impact on consumers, the national economy as well as currency exchange rates.
As inflation increases, the value of the U.S. Dollar drops because the overall prices for goods and services are increasing. Higher prices lead to a decline in the purchasing power of a dollar. As a result, consumers often adjust their purchasing behavior and spend less of their disposable income. This effect of decreased purchasing power can lead to a decrease in overall consumer spending around the country. Decreased consumer spending is often an indicator of slow economic growth or economic recession.
Positive and Negative Income Effect
When the price of goods and services increases, the consumer’s inflation adjusted income decreases. Inflation adjusted income is what economists refer to as real income. This is a negative effect of purchasing power decrease, because consumers have to spend more money on the goods or services after the price increase than they had to spend before the increase. When the price of goods and services decreases, it increases real income. Consumers now spend less on a good or service after the price decrease, giving them more purchasing power.
Goods and Services Substitution
When prices for goods and services increase consumers have less purchasing power. In this case, consumers may substitute a cheaper option in place of the more expensive option. Demand for the more expensive good or service decreases and demand for the cheaper option increases. Economists refer to this as the substitution effect. When the price of similar goods and services remains the same, consumers often switch between products. Since there is no difference in price, the purchasing power is the same and does not generally factor into the consumer’s choice between the two.