Purchase power is a measure of what your money can buy - here's how it can impact your finances
- Purchasing power refers to how much you can buy with a unit of currency, such as a dollar.
- If your purchasing power drops, your money may become less valuable or useful over time.
- Inflation impacts purchasing power, but changing wages can also impact your finances.
If you find a $100 bill that was printed 20 years ago, it will still be worth $100 dollars. But you can probably buy a lot less with it today than you could have when it first came off the printing press.
Inflation measures how prices for goods and services increase over time. But purchasing power looks at the flip side - how much can a single unit of currency buy?
What is purchase power?
Purchase power is a measure of how many goods or services you can buy with a unit of currency. The currency might be a commodity, such as gold, silver, or a government-issued currency, such as the US dollar (USD).
"Imagine that you make the same salary as you did twenty years ago," says Robert Johnson, a professor of finance at Creighton University's Heider College of Business and CEO and chairman of the Economic Index Associates. "You would be able to buy considerably fewer goods because the prices of those goods (denominated in dollars) have generally risen."
If you haven't experienced this first hand, you may have heard someone talk about how they used to buy a soda, sandwich, or gasoline for much less money back in "their time."
Purchase power and inflation
Economists can track changes in purchasing power to better understand the impact of inflation on consumers' buying power. In a sense, purchasing power and inflation are two sides of the same coin. Purchasing power measures what a unit of currency can buy, while inflation measures rising 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 tracker of inflation. It uses quarterly survey data to gather the average prices for a market basket of consumer goods and services in urban areas. The basket includes common household purchases, such as cereal, milk, coffee, clothing, and medical care.
Quick tip: There are different types of CPI measures. For example, the "Core CPI" excludes food and energy costs, as they may be prone to volatile price changes. But it also only focuses on urban consumers.
The CPI surveys even account for "shrinkflation" (e.g., when a cereal box costs the same, but there's less cereal inside) by comparing prices per unit. For example, you can look up the price of sliced bacon per pound and see how it's changed since 1980.
Purchase power loss and gain
Purchasing power losses and gains reflect changing prices of goods. For instance, "as inflation rises, purchasing power falls because one needs more units of currency to acquire the same basket of goods," says Johnson.
Inflation and deflation can directly impact purchasing power, but they might not be the only factors. For example, a new government regulation could impact an entire industry and lead to changing prices for goods and services in that sector. Or a new technology could increase manufacturing efficiency, decreasing the cost of certain products.
Purchasing power in the real world
While purchasing power looks at what a unit of currency can buy, it doesn't account for changing wages. "Real wage" changes are a measure of changing wages minus inflation. In effect, it's a measure of a household's purchasing power over time.
In the news: Inflation increased during the pandemic, but wages rose above pre-pandemic levels for many workers. Even if there's high inflation, your personal buying power could increase if your wages rise even faster.
There are also other factors you may want to consider when trying to determine your future buying power and budget.
For example, cell phones may be a large expense for households today - but they're a relatively new invention that couldn't 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 doesn't take into account improvement in many goods that may be in a basket," says Johnson. "The price of televisions have dropped over time, [but] the quality of those goods has increased over time." Johnson points to medical care as another example. While medical care costs might have increased over time, the advances and quality of care may have also increased.
Your individual buying power can also be influenced by other factors, including government and manufacturers' policies. For instance, a bottle of Coca-Cola cost five cents for over 70 years, in part because the vending machines were designed to only accept nickels. Or, you might pay a lot more (or less) for a gallon of gas or pack of cigarettes than someone else depending on the 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 US 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 PPP.
PPP estimates can be useful when comparing living standards and economic output from 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 might not directly impact your investments, but it could be important to consider how much your money can buy - especially when you're preparing for or already in retirement.
Many retirees use a fixed-income investment strategy by buying assets like bonds, certificates of deposit (CDs) and annuities. These can provide a stable income and may be relatively low risk. But if inflation is at 5% and you're locked into a bond that's paying 5%, you're only making enough money to offset rising costs.
To account for changes in purchasing power, many retirement calculators let you choose an inflation rate. You can then see how your portfolio or plan may work in different circumstances.
The financial takeaway
Purchasing power measures how much a unit of currency can buy. It's often impacted by inflation and deflation - the changing cost of goods and services. But policy changes and major events or industry changes can also influence purchasing power.
Changes in purchasing power can play an important role in national and local policymaking. And you may want to consider your future purchasing power as you design or update your investment strategy. But also beware of and account for its shortcomings when trying to forecast your future expenses.