Does the term “buying power” make you think about spending your money on brands you believe in? Turns out the phrase isn’t actually about your ability to make a difference (or a statement) with your buying behavior.
Here’s what you need to know about purchasing power and how inflation affects it.
What is purchasing power?
In simple terms, purchasing power means how much your money can buy – its “purchasing power”. You lose buying power when prices go up and gain buying power when prices go down. But we cannot talk about purchasing power without also looking at “inflation”, which changes the value of a currency over time.
As you know, what a dollar buys today is not what a dollar bought 10 years ago. And while we don’t want to “OK Boomer” anyone, it’s easy to feel a bit annoyed when an older person exclaims at the price of a product or service and says, ” Wow, it only cost x”. That’s when you want to remind them that the federal minimum wage was just $0.25 when it was introduced in 1938, and now it’s $7.25, well higher in many states. Yes, prices were much lower when baby boomers were early in their careers, but so were salaries.
If your salary remains the same but prices rise due to inflation, your purchasing power will decrease and you will not be able to afford to buy as much as before.
Inflation is tracked by the Consumer Price Index (CPI), which measures the cost of a basket of 175 consumer goods and services, ranging from food to healthcare to housing prices. Each month, the US Bureau of Labor Statistics (BLS) calculates an average cost of these items to determine how much it has changed since the previous record. This identifies the level of inflation and thus shows you the current purchasing power of your dollar.
It is important to note that the basket of goods is an average for households, but may not reflect your individual consumption. For example, the headline CPI might only rise by 2% (which is the inflation target that the country’s central bank, the Federal Reserve, uses to inform its policies). But some items, such as intercity bus fees and health insurance, have recently risen much more – 21.8% and 18.6%, respectively – while other costs, such as those for cars and trucks. occasion, have declined. So if you’re paying for your own health insurance and you haven’t bought a used car, you might feel like you have less buying power since health insurance has risen more sharply and represents a larger percentage of your personal budget.
What does purchasing power affect?
Purchasing power is not just about what you can buy with your money. It also affects stock prices, as well as general economic health. Indeed, if inflation leads to a significant decline in purchasing power and the cost of living increases, it will lead to more cash-strapped consumers.
Interest rates also affect your individual purchasing power; for example, a 1% drop in interest rates can result in a monthly savings of $167 on a $200,000 mortgage. Lower mortgage rates mean your dollars can go further since the total amount you will owe on your monthly mortgage payments will be lower.
Economists also look at purchasing power between countries. They often use the theory of purchasing power parity (PPP), comparing a basket of goods in one currency to that of another, after taking exchange rates into account. PPP is basically the exchange rate at which one country’s currency would have to convert to another country’s currency in order to purchase the same amount of goods and services. Simply put: if the value of a foreign currency increases against the dollar, it can affect an American’s purchasing power in that country.
How has purchasing power changed over the years?
While purchasing power experiences annual changes, there have been some historical examples of severe inflation, and even hyperinflation, which is when rapid increases in prices cause inflation to skyrocket. . A recent example of hyperinflation occurred in Venezuela, which saw its hyperinflation rate soar to 10 million percent.
The United States has not experienced such inflation. The CPI offers a reliable snapshot of inflation in this country over the years. Created in 1917 during the First World War, the CPI was calculated until 1913 using available data. Between 1913 and 1919, inflation increased by almost 10%, compared to calmer periods of 2 to 3% since the 1950s, with the exception of the 1970s and 1980s when average inflation exceeded 7% respectively. and 5%, thus creating purchasing power. to fall.
To find out how purchasing power has changed over the years, take a look at the American Institute for Economic Research’s Cost of Living Calculator, where you can enter a year and an amount and see what worth today. For example, $100 in 1913 would be worth $2,581.21 today.
How does purchasing power affect my investments?
Rising inflation will erode the purchasing power of your investments. In other words, the amount of money you have invested will be worth less when you need it.
This is why it is important to focus on investments that will earn a rate of return greater than the value of inflation. When deciding where you intend to invest, consider factors such as your time horizon and risk tolerance.
A longer time horizon theoretically allows for a more aggressive investment portfolio, with more time for the stock market to recover even if it hits one of its inevitable lows. In contrast, a more conservative portfolio that relies on asset classes with lower fixed yields, as you would with products like CDs and bonds, may actually lose purchasing power over time. years due to inflation. (The annual inflation rate in the United States was 2.1% for the 12 months ending November 2019, according to data from the United States Department of Labor, while the national average for a two-year CD was 0 .64%.)
Also remember that the earlier you start investing, the better. This is because you’ll have more time to use the power of compound interest, which means you’ll earn interest on your interest multiple times, which can help your account grow significantly in the long run. (Acorns lets you start investing in a wide range of stocks and bonds with just spare change. Learn more.)
The overall goal of an investment is to have more money in the future when you need it, so it’s important to understand the effect inflation can have when developing your investment strategy. ‘investment.