Purchasing power is the value of a currency explained by the amount of goods or services one unit of money can buy. Over time, purchasing power can diminish due to inflation, as rising prices reduce the quantity of goods or services that can be bought. This concept is often referred to as a currency’s buying power.
In investment contexts, purchasing power—or buying power—refers to the credit amount available to a customer, based on the marginable securities in their brokerage account.
Key Takeaways
- Purchasing power measures the quantity of goods or services one unit of currency can buy at a specific time.
- Inflation erodes a currency’s purchasing power over time.
- Central banks manipulate interest rates to stabilize prices and maintain purchasing power.
- One metric for purchasing power in the U.S. is the Consumer Price Index (CPI).
- Globalization has interconnected currencies, making responsible management of purchasing power globally imperative.
Understanding Purchasing Power
Purchasing power affects various economic activities, from consumer purchases to investments and overall economic health.
Inflation reduces purchasing power by decreasing the value of money. In economic terms, this is equivalent to an increase in the price of goods or services. To measure purchasing power traditionally, compare the price of goods or services against a price index, such as the Consumer Price Index (CPI).
Imagine working the same job your grandfather did 40 years ago. Today, you would need a much higher salary to maintain the same quality of life. Similarly, a homebuyer with a $300,000 to $350,000 budget 10 years ago had more and better options than someone today in the same price range.
A severe decline in purchasing power caused by excessive inflation can have dangerous economic impacts, such as increased cost of living, higher interest rates, and falling credit ratings, potentially leading to an economic crisis.
Purchasing Power and CPI
Governments institute policies and regulations to protect currency purchasing power and keep the economy stable. They also monitor economic data to gauge changes. For example, the U.S. Bureau of Labor Statistics (BLS) calculates price changes through the Consumer Price Index (CPI).
CPI, a measure of inflation and purchasing power, calculates price changes in consumer goods and services, particularly transportation, food, and medical care. Changes measured by CPI can signal shifts in the cost of living and potential deflation.
Purchasing Price Parity
Purchasing Price Parity (PPP) is an economic theory that estimates the amount an item should be adjusted for parity between two countries’ exchange rates. PPP helps compare economic activity, income levels, cost of living, and inflation rates between countries.
The World Bank’s International Comparison Program provides data on purchasing power parities between various countries.
Purchasing Power Loss or Gain
Purchasing power loss or gain measures how much consumers can buy with a given amount of money. Purchasing power decreases when prices increase and increases when prices decrease.
Example: Laptops that cost $1,000 two years ago but cost $500 today represent a purchasing power gain, allowing you to buy a laptop and additional goods valuing $500 with the original $1,000.
Examples of Purchasing Power Loss
Germany After WWI
Germany experienced drastic hyperinflation in the 1920s post-WWI due to hefty reparations payments, leading to an economic collapse and rendering the German mark nearly worthless.
The 2008 Financial Crisis
During the 2008 financial crisis, there was a significant drop in purchasing power. Governments globally initiated policies like the Federal Reserve’s quantitative easing to stabilize economies and protect purchasing power.
Investment Strategies Against Purchasing Power Risk
Retirees and those on fixed incomes are particularly wary of purchasing power loss. They should ensure their investments provide returns equal to or greater than the inflation rate.
Investments like Treasury inflation-protected securities (TIPS) and commodities like oil can help mitigate purchasing power risks. Fixed-rate investments such as bonds are more vulnerable to purchasing power risk.
The Bottom Line
Long-term investors understand that purchasing power loss significantly impacts their investments. Elevating inflation rates mean that goods and services become pricier, decreasing purchasing power.
It is crucial to seek investment returns that exceed the inflation rate and remain aware of international economic trends affecting long-term investments.
Related Terms: inflation, deflation, consumer price index, purchasing power parity, hyperinflation, quantitative easing.
References
- The World Bank. “International Comparison Program (ICP)”.
