Definition, examples, how inflation affects it

  • Purchasing power refers to the amount you can buy with a monetary unit, such as a dollar.
  • If your purchasing power decreases, your money may become less valuable or useful over time.
  • Inflation has an impact on purchasing power, but the evolution of wages can also have an impact on your finances.
  • Visit Insider’s Investment Reference Library for more stories.

If you find a $ 100 bill that was printed 20 years ago, it will still be worth $ 100. But you can probably buy a lot less today than when it came out of print.

Inflation measures how the prices of goods and services increase over time. But purchasing power looks at the other side of the coin: how much can a single unit of currency buy?

What is purchasing power?

Purchasing power is a measure of how many goods or services you can buy with a monetary unit. Currency can be a commodity, such as gold, silver, or a government-issued currency, such as the United States dollar (USD).

“Imagine making the same salary as twenty years ago,” says Robert Johnson, professor of finance at Heider College of Business at Creighton University and CEO and president of Economic Index Associates. “You would be able to buy considerably less goods because the prices of those goods (denominated in dollars) have generally gone up.”

If you haven’t experienced this firsthand, you may have heard someone talk about how they bought a soda, sandwich, or gasoline for a lot less money in their “time.”

Purchasing power and inflation

Economists can follow changes in purchasing power to better understand the impact of inflation on the purchasing power of consumers. In a sense, purchasing power and inflation are two sides of the same coin. Purchasing power measures what a monetary unit can buy, while inflation measures the rise in prices.

What is inflation?

Inflation is the increase in the prices of goods and services over time. The Consumer Price Index (CPI) is a commonly used indicator of inflation. It uses quarterly survey data to collect the average prices of a basket of consumer goods and services in urban areas. The basket includes everyday household purchases, such as cereals, milk, coffee, clothes and medical care.

CPI surveys even take “shrinkage” (for example, when a box of cereal costs the same price, but there is less cereal in it) into account when comparing unit prices. For example, you can look at the price of sliced ​​bacon per pound and see how it has changed since 1980.

Purchase loss and gain of power

Purchasing power gains and losses reflect changes in the prices of goods. For example, “as inflation increases, purchasing power decreases because it takes more currency units to acquire the same basket of goods,” says Johnson.

Inflation and deflation can have a direct impact on purchasing power, but they may not be the only factors. For example, new government regulations could impact an entire industry and lead to changes in the prices of goods and services in that sector. Or a new technology could increase manufacturing efficiency, lowering the cost of some products.

Purchasing power in the real world

While purchasing power examines what a monetary unit can buy, it does not take into account the evolution of wages. Changes in “real wages” are a measure of the evolution of wages less inflation. Indeed, it is a measure of the purchasing power of a household over time.

There are also other factors you may want to consider when trying to determine your future purchasing power and budget.

For example, cell phones can be a big expense for households today, but it is a relatively new invention that could not have been included in previous “baskets of goods”. Who knows what goods or services will be invented and added to the “basket” later.

“Also, purchasing power does not take into account the improvement of many products that may be in a basket,” explains Johnson. “The price of televisions has gone down over time, [but] the quality of these products has increased over time. Johnson cites medical care as another example. Although the costs of medical care may have increased over time, the progress and quality of care may also have increased.

Your individual purchasing power can also be influenced by other factors, including government and manufacturer policies. For example, a bottle of Coca-Cola cost five cents for over 70 years, in part because vending machines were designed to only accept nickels. Or, you could pay a lot more (or less) for a gallon of gasoline or a pack of cigarettes than someone else based on local tax rates.

What is purchasing power parity (PPP)?

Rather than focusing on a single currency, purchasing power parity (PPP) measures the purchasing power of currencies between countries.

As an example, think of a gallon of milk that costs $ 3 in the United States and 30 pesos in Mexico. The PPP exchange rate would be $ 1 to 10 pesos. If the market exchange rate is different, then it deviates from the PPP.

PPP estimates can be useful for comparing living standards and economic output in different countries. In less serious terms, The Economist’s Big Mac Index explores the concept by comparing the cost of a Big Mac in different countries.

Can purchasing power impact your investments?

Purchasing power may not have a direct impact on your investments, but it can be important to consider how much your money can buy, especially when you are preparing or already for retirement.

Many retirees use a fixed income investment strategy by purchasing assets like bonds, certificates of deposit (CDs) and annuities. These can provide a stable income and can present a relatively low risk. But if inflation is at 5% and you’re stuck on a bond that pays 5%, you’re only making enough money to offset the rising costs.

To account for changes in purchasing power, many retirement calculators allow you to choose an inflation rate. You can then see how your wallet or plan can perform under different circumstances.

The financial report

Purchasing power measures how much a monetary unit can buy. It is often affected by inflation and deflation, ie changes in the cost of goods and services. But policy changes and major events or changes in the industry can also influence purchasing power.

Changes in purchasing power can play an important role in shaping national and local policies. And you may want to consider your future purchasing power when designing or updating your investment strategy. But also beware and consider its shortcomings when trying to forecast your future spending.


About Rodney Fletcher

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