Question

What Happens to the Purchasing Value of Money during deflation?

1) Increases

2) Decreases

3) It changes but there is no way of knowing the direction or the magnitude of change.

4) No change, only the price changes.

Only 1 option is correct, please explain with reason.

Answer 1

Purchasing value of money impies that the purchasing power of money. It tells us that how many units of a good and services each unit of money (let's say each dollar) can purhcase.

Formula: Purchasing value of money = (money / Price level)

-------------------

Deflation is the decrease in general price level of goods and services in an economy.

If there is decrease in price level of goods and services (or deflation), then the purchasing power of money will increases.

-----------------

Let's understand it with the help of an example:

Assume you have $100 with you. And the genreal price level in economy is 10.

=> Purcasing Value of money = $100 / 10

=> Purchasing Value of money = 10

--

Now suppose there is deflation in economy, and general price level decreases from 10 to 5

Purchasing value of money (after deflation) = $100 / 5

=> Purchasing value of money (after deflation) = 20

As we can see that, the purchasing power of money (or $100) increases from 10 t0 20 due to deflation.

Answer: Option (1) i.e., increases

-----------------------------------------------------------

If you like my work, please hit the like button :)

-----------------------------------------------------------------