Purchasing power is the goods and services a unit of money can actually buy. It is the only measure of money that a household ultimately cares about, and it moves independently of the nominal figures the household sees on its statements.
- 01Compute the real return on an investment given nominal return and inflation.
- 02Distinguish currency depreciation from domestic inflation.
- 03Read a portfolio in real terms, not nominal.
Currency depreciation
A currency loses purchasing power in two ways. It can lose value at home — the same currency buys fewer domestic goods, which is inflation. Or it can lose value against other currencies — the same currency buys fewer imported goods and fewer units of foreign currency, which is depreciation. Over long periods the two tend to converge; over short periods they can diverge sharply.
Inflation-adjusted wealth
A household worth $500,000 in 2015 dollars is worth substantially less in 2025 dollars, even if the number on the balance sheet is unchanged. Serious households track net worth both nominal and real. The real trend line is the honest scoreboard; the nominal line flatters the passive holder.
Real versus nominal returns
A bond paying 5% in a year of 3% inflation earns a real return of roughly 2% (precisely, 1.05 / 1.03 − 1 ≈ 1.94%). A bond paying 5% in a year of 6% inflation earns a real return of roughly −1%. Investors who reason in nominal terms will systematically over-allocate to fixed-income assets during inflation and systematically over-allocate to cash during deflation. Both errors compound.
Real return calculation
A one-year T-bill yields 4.5%. CPI inflation over the same year runs 3.2%. Real return = (1.045 / 1.032) − 1 = 0.01260 = 1.26%. The naïve subtraction (4.5 − 3.2 = 1.3) is close enough for most household purposes, but the exact formula matters when returns and inflation are large.
- Purchasing power = what money will actually buy, at home and abroad.
- Real return ≈ nominal return − inflation, more precisely (1+r) / (1+i) − 1.
- The honest household scoreboard is real net worth, not nominal.