What is purchasing power? Definition, importance and related concepts

Purchasing power has an inverse relationship with inflation.

What does purchasing power mean?

Do you remember when you could buy two Big Mac McDonalds with one $5 bill in 2000? By 2020, however, a five would only secure you a of the fast food chain’s most iconic burgers, perhaps with a few changes to spare. Why? Because the purchasing power of the dollar decreases over this 20-year period.

Purchasing power is the value of money in terms of the actual goods and services it can buy. The purchasing power of a currency decreases over time as the price of a country’s goods and services increase. More rarely, purchasing power can increase if prices fall.

How is purchasing power related to inflation and the cost of living?

Inflation is the process of increasing the prices of goods and services over time. Whenever inflation occurs (i.e. prices rise), purchasing power decreases because each currency unit loses value in terms of what it can be exchanged for.

During periods of deflation, which are much rarer, prices fall, so purchasing power increases. In other words, purchasing power and inflation have a reverse relationship.

Cost of living refers to the amount of money needed by an individual to maintain a certain lifestyle. Regular and recurring expenses such as rent, gas, food and health care are taken into account when considering the cost of living. When the cost of living increases (due to inflation in the prices of goods and services), purchasing power decreases because more foreign currency is needed to buy the same basic necessities.

What is purchasing power parity?

Purchasing Power Parity (PPP) is an economic theory that postulates that goods and services should cost the same amount everywhere once currencies are exchanged. In other words, one US dollar should be able to buy the same amount of goods anywhere when converted into the local currency.

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That is, if a box of cereal costs $3 in country A and $4 in country B, then the exchange rate from currency A to currency B should be 3:4 (or 0.75) assuming absolute purchasing power parity.

It is important to note that real exchange rates are not influenced by relative purchasing power – exchange rates are determined by supply and demand in the foreign exchange markets. PPP is just a way to compare currencies in terms of the goods and services they can pay for.

In reality, a number of factors cause actual exchange rates to differ from the rates that would be implied by PPP. Transportation costs, tariffs, different inflation rates, supply chain issues, and countless other factors can cause currencies to have different purchasing power.

How to Calculate Implicit Exchange Rates with PPP

If you wanted to calculate the exchange rate that would be implied by purchasing power parity theory, you would simply compare the cost of a basket of identical goods between two currencies

PPP exchange rate formula

S = P1 / P2

Where . . .

S: Implicit exchange rate
P1: Price of a basket of goods in a country
P2: Price of the same basket of goods in a second country

Example of PPP exchange rate

Suppose a hypothetical basket of goods costs $14 in country A’s currency, while the same basket of goods costs $22 in country B’s currency. What should be the exchange rate between the two currencies assuming parity purchasing power?

S = P1 / P2

S=$14/$22

S = 0.64

Thus, each unit of currency B should be worth approximately 0.64 units of currency A, assuming purchasing power parity.

What is a purchasing power index?

A purchasing power index is a tool that assigns a value to each country based on the purchasing power of its currency relative to other countries. In this 2020 Purchasing Power Index from Numbeo, for example, the scores range from around 20 to 120, with higher scores indicating that a country’s currency has more absolute value in terms of what it can buy.

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