A hundred dollars buys less today than it did twenty years ago. That decline is a loss of purchasing power, the amount of goods and services a unit of money can buy. Inflation erodes purchasing power. Deflation increases it. Wages may rise, but if prices rise faster, workers are worse off in real terms.

Economists distinguish between nominal and real values. Nominal wages are what you see on a paycheck. Real wages adjust for inflation and reflect what you can actually buy. A worker who gets a 3 percent raise when inflation is 5 percent has taken a real pay cut, even though the nominal number went up. Governments, unions, and central banks all track this gap closely.

Purchasing power varies across countries too. A dollar buys more in Thailand than in Switzerland. That is why economists use purchasing power parity, or PPP, to compare living standards. China's GDP is smaller than the United States' at market exchange rates, but larger when adjusted for PPP, because goods and services cost less there. PPP is not perfect, but it gives a clearer picture of how far a paycheck actually goes.

Related measures

• Real wages: nominal wages adjusted for inflation
• Consumer Price Index: tracks changes in purchasing power
• Purchasing power parity: compares currencies by what they buy
• Real interest rate: nominal rate minus inflation