Definition of purchasing power


What is purchasing power?

Purchasing power is the value of a currency expressed in terms of the number of goods or services that a unit of currency can buy. Purchasing power is important because, all things being equal, inflation decreases the number of goods or services you could buy.

In investment terms, purchasing power is the dollar amount of credit a client has available to purchase additional securities against the marginable securities existing in the brokerage account. Purchasing power can also be referred to as the purchasing power of a currency.

What is purchasing power?

Understanding purchasing power

Inflation reduces the value of a currency’s purchasing power, which in turn increases prices. To measure purchasing power in the traditional economic sense, you would compare the price of a good or service to a price index such as the Consumer Price Index (CPI). One way to think about purchasing power is to imagine if you had the same salary as your grandfather 40 years ago. Today, you would need a much higher salary just to maintain the same quality of life. Likewise, a buyer looking for a home 10 years ago in the $ 300,000 to $ 350,000 price range had more options to consider than people have now.

Purchasing power affects all aspects of the economy, from consumers buying goods to investors and stock prices to a country’s economic prosperity. When the purchasing power of a currency declines due to excessive inflation, serious negative economic consequences arise, including rising costs of goods and services contributing to a high cost of living, as well as rising rates. high interest rates affecting the global market, and lower credit ratings as a result. All of these factors can contribute to an economic crisis.

Purchasing power and CPI

As such, a country’s government institutes policies and regulations to protect the purchasing power of a currency and maintain a healthy economy. The consumer price index is a method to monitor purchasing power. The United States Bureau of Labor Statistics (BLS) measures the weighted average prices of consumer goods and services, particularly transportation, food, and medical care. The CPI is calculated by averaging these price changes and is used as a tool to measure changes in the cost of living, as well as a marker to determine the rates of inflation and deflation.

One concept related to purchasing power is purchasing price parity (PPP). PPP is an economic theory that estimates the amount that must be adjusted to the price of an item, given the exchange rates of two countries, in order for the exchange to match the purchasing power of each currency. PPP can be used to compare countries’ income levels and other relevant economic data regarding the cost of living, or possible rates of inflation and deflation.

Key points to remember

  • Purchasing power is the amount of goods or services that a monetary unit can buy at a given time.
  • Inflation tends to erode the purchasing power of a currency over time.
  • Central banks try to keep prices stable by maintaining the purchasing power of money by setting interest rates and other mechanisms.

The history of purchasing power

Historical examples of severe inflation and hyperinflation – or destruction of the purchasing power of a currency – have shown that there are several causes for such a phenomenon. Often costly and devastating wars will cause economic collapse, especially for the losing country like Germany in World War I (WWI).

In the aftermath of World War I in the 1920s, Germany experienced extreme economic hardship and almost unprecedented hyperinflation, in part because of the huge amount of reparations Germany had to pay. Unable to pay for these repairs with the suspect German mark, Germany printed paper banknotes to buy foreign currency, resulting in high inflation rates that made the German mark worthless with purchasing power non-existent.

Effects of purchasing power today

Today, the effects of the loss of purchasing power are still being felt in the aftermath of the 2008 global financial crisis and the European sovereign debt crisis. With increased globalization and the introduction of the euro, currencies are even more inextricably linked. As such, governments put in place policies to control inflation, protect purchasing power, and prevent recessions.

For example, in 2008 the US Federal Reserve kept interest rates near zero and implemented a plan called quantitative easing. The initially controversial quantitative easing essentially saw the US Federal Reserve buy government securities and other market securities to lower interest rates and increase the money supply. The idea is that a market will then experience an increase in capital, which stimulates the increase in lending and liquidity. The United States halted its quantitative easing policy once the economy stabilized, in part because of the above policy and a host of other complex factors.

The European Central Bank (ECB) also continued quantitative easing to help stop deflation in the euro area after the European sovereign debt crisis and strengthen the purchasing power of the euro. The European Economic and Monetary Union has also established strict regulations in the euro area on the accurate reporting of sovereign debt, inflation, and other financial data. Typically, countries attempt to keep inflation at a rate of 2%, as moderate levels of inflation are acceptable, with high levels of deflation leading to economic stagnation.

Loss / gain in purchasing power

Purchasing power loss / gain is an increase or decrease in what consumers can buy with a given amount of money. Consumers lose purchasing power when prices rise and gain purchasing power when prices fall. The causes of the loss of purchasing power include government regulations, inflation, and natural and man-made disasters. The causes of purchasing power gain include deflation and technological innovation.

An official measure of purchasing power is the Consumer Price Index, which shows how the prices of consumer goods and services have changed over time. Globally, the World Bank’s international comparison program also publishes data on purchasing power parities between different countries.

As an example of purchasing power gain, if laptops cost $ 1,000 two years ago and today they cost $ 500, consumers have seen their purchasing power increase. In the absence of inflation, $ 1,000 will now buy a laptop plus an additional $ 500 in merchandise.

Investments that protect against purchasing power risk

Retirees should be particularly aware of the loss of purchasing power since they live on a fixed sum of money. They must ensure that their investments earn a rate of return equal to or greater than the rate of inflation so that the value of their nest egg does not decrease each year.

Debt securities and investments that promise fixed rates of return are the most sensitive to purchasing power risk or inflation. Fixed annuities, certificates of deposit (CDs) and treasury bills all fall into these categories. Buying a long-term bond also exposes your money to the risk of losing purchasing power, as a fixed rate can be so low that it keeps your money at net zero, rather than growing it.

There are many investments or strategies that can help protect investors against purchasing power risk. For example, commodities like oil, grains, and metals enjoy pricing power during inflation because they have always been valued.

Purchasing power faq

What does purchasing power mean?

Purchasing power is the value of a currency expressed in terms of the number of goods or services that a unit of currency can buy.

What is purchasing power parity?

Purchasing power parity is an economic theory that estimates the amount that must be adjusted to the price of an item, given the exchange rates of two countries, for the exchange to match the purchasing power of each currency. . Essentially, it takes into account various factors differentiating various currencies to determine the cost of an item, such as a gallon of milk, in various countries.

How to calculate purchasing power?

Purchasing power is calculated using the United States Bureau of Labor Statistics Consumer Price Index, which measures the weighted average of the prices of consumer goods and services, particularly transportation, food and medical care. The CPI is calculated by averaging these price changes and measures changes in the cost of living, as well as considered a marker for determining rates of inflation and deflation.

What is purchasing power by country?

Purchasing power by country is measured using purchasing power parity, which makes it possible to calculate the affordability of goods and services taking into account all other factors of exchange.

What is an example of purchasing power?

As an example of purchasing power gain, if laptops cost $ 1,000 two years ago and today they cost $ 500, consumers have seen their purchasing power increase. In the absence of inflation, $ 1,000 will now buy a laptop plus an additional $ 500 in merchandise.

The bottom line

Long-time investors will know that purchasing power can have a huge impact on their investments if they don’t watch it closely. All other things being equal, inflation decreases the number of goods or services you could buy with the same amount of money, which means investors need to look for ways to actively generate a return above the rate of return. current inflation. The most advanced will follow other international economies, aware of the impact of the parity of purchase prices on their long-term investments.

About Sharon Joseph

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