In the field of economics, an important concept to understand is purchasing power.
Understanding of purchasing power is important for every individual with global money printing.
In the coming years, inflation is likely to be high. Without the understanding of purchasing power, individuals will see a decline in their standard of living.
The definition of purchasing power is the amount of goods and services that can be purchased with one unit of currency.
So why does it matter?
Let’s discuss with an example.
Assume Mr. X has $100 in Year 1. Further, a basket of goods and services cost $100.
Therefore, Mr. X can buy one unit of the basket of goods and services with that $100.
In Year 2, inflation is very high at 10%. However, Mr. X gets a wage growth of only 5%.
Therefore,
Mr. X has $105 (5% wage growth) in his pocket. However, the basket of goods that cost $100 in Year 1, now costs $110 (10% inflation).
In Year 2, Mr. X can only buy 0.95 units of goods and services.
Clearly, the purchasing power of Mr. X declines.
If this happens every year, the purchasing power will continue to decline and Mr.
X will be able to purchase a smaller quantity of the basket of goods and services.
How to increase purchasing power?
Given this example, the key point to note is as follows – If inflation is 10%, a person needs wage growth of at least 10% to maintain purchasing power.
Even if wage growth is not 10%, the person has to ensure that his/her savings are invested in asset classes that generate returns in excess of 10%.
In the United States, interest rates are near-zero levels.
How will you generate 10% returns by keeping your money in the bank?
The answer is to park money in relatively risky asset classes. Not all of your savings. But at least 30% of your savings.
As an example, investors can buy stocks, investment grade bonds, gold, cryptocurrency to ensure that annual returns beat inflation.
Let me give some facts to prove my point –
In the last 10-years, U.S. stocks have delivered an annual average return of 13.5%
In the last 10-years, gold has delivered an annual average return of 4.5%
In the last 10-years, U.S. cash has delivered an annual average return of 0.5%
Clearly, if one was invested in equities and gold, it would have been easier to beat inflation and maintain purchasing power.
Therefore, the key point is to remain diversified and to go underweight on fiat currency. This is possibly good news for cryptocurrency.