How purchasing power reduces when currency is commodity money(say gold)

Question

First of all I am new to Economics. I'm a B.Sc.(Mathematics) final year student. I was curious to learn Economics so I started with "Economics in one lesson" by Henry Hazlitt.

In this book I encountered few phrases like 'inflation' and 'purchasing power'. On Wikipedia I started reading about purchasing power. I was even unable to understand its first paragraph. The first para goes like:

Purchasing power (sometimes retroactively called adjusted for inflation) is the number and quality or value of goods and services that can be purchased with a unit of currency. For example, if one had taken one unit of currency to a store in the 1950s, it is probable that it would have been possible to buy a greater number of items than would be the case today, indicating that one would have had a greater purchasing power in the 1950s. Currency can be either a commodity money, like gold, silver and bitcoin, or fiat money emitted by government sanctioned agencies.

Suppose I have 10,000 in the year 2000 and at the same time my friend also have 10,000. We both wanted to save this money for future. I decided to put this cash in my lock whereas my friend decided to buy gold of it. For simplicity say my friend bought 1 kg of gold.

Now in year 2010, after 10 years, due to inflation, our purchasing power is reduced. Now my question is that in this 10 year period due to inflation the price of gold is also high, so for the same amount of 10,000 my purchasing power is reduced much more than my friend's. Why or how?

As I said I'm new to Economics so please be simple while explaining.

Any suggestions for further reading will also be appreciated.

Answer 1

Here is a chart from The Economist in July 2010 showing the nominal and real (i.e. inflation adjusted) price of gold in US dollars back to 1970. The nominal price later continued to rise until 2012 and then fell, and it is currently at about its 2010 level; the real price also rose and then fell and is currently below its 2010 level. The lines would look different in other currencies

So while the purchasing power of most currencies including the US dollar tends to fall over ten-year periods due to inflation, the purchasing power of gold (shown by the real line) may rise or fall depending on precisely which ten-year period you choose. For example it rose from 2000 to 2010 and from 1970 to 1980 but fell from 1980 to 1990 and from 1990 to 2000; indeed from 1980 to 2000 the purchasing power of gold fell faster than the purchasing power of the dollar

An additional consideration is that you can store your currency in a bank by depositing it, and you can then receive interest on it, which may offset the decline in the purchasing power. If you store gold in a bank, the bank is likely to charge you a storage fee and you will not receive interest

Answer 2

The price of a specific commodity (e.g., gold) need not have gone up, it can have changed in any direction. Your friend bought an asset that, in your example, increased in value. As such, it provided protection against the general increase in prices. It could have turned out that the price of gold fell during that period and she was worse off than you.

In order to determine the impact of rising prices on the purchasing power of money, we use price indices to 'deflate' the monetary values. Say the price index was 100 in 2000 and 125 in 2010. In keeping with your example, assume the price of gold was 10,000 per kg in 2000 and 12,000 per kg in 2010. If both your and your friend's purchasing power in 2000 was 10,000, we'd say that yours would have been reduced to

$$10,000 \frac{100}{125}=8,000.$$

We'd say that the \$10,000 you still have in 2010 are equivalent to \$8,000 dollars of 2000. Sometimes we speak of the 10,000 year 2010 dollars as "8,000 year 2000 dollars."

For your friend things are a little better:

$$12,000 \frac{100}{125}=9,600.$$

You'd both be worse off, but your friend would have lost only 400 year 2000 dollars to the 2,000 year 2000 dollars you lost.

Of course this is heavily dependent of what has happened to the price of gold during that period. If, instead, it had fallen to 9,000, then your friend's gold investment is worse than your money investment, because its year 2000 dollars value would be

$$9,000 \frac{100}{125}=7,200.$$