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Saturday, March 02, 2024

Purchasing power: what it is and how it works

Purchasing power: What it is and how it works

09.15.2023

Purchasing power, or buying power, refers to how much you can buy with a specific amount of money. It goes up and down over time according to various economic factors.

Let’s dig into how you can mitigate the risk to your purchasing power.

What is purchasing power?

Purchasing power is what you can buy with a specific unit of currency, such as a dollar or $100. Your purchasing power is impacted by a number of factors, including inflation

How purchasing power works

In 2001, the average price of a movie ticket was $5.66. In 2021, costs averaged $9.57.1 This is a very specific example, but you can see how the purchasing power of $10 is different. In 2001, $10 may get two people into the cinema. Ten years later, it gets one person in.

As the price of goods increases, you can purchase less. That means the purchasing power of the dollar is lower. Swap out the dollar for any other currency, such as pesos or yen, and the same is true.

If the value of or purchasing power of the dollar or other currency falls, however, that doesn't necessarily mean your purchasing power is lowered. If your income has kept up with inflation or indexation has helped to curtail inflation, you may be able to purchase as much as you previously did.

For example, if you made $10 per hour in 2001 and $20 per hour in 2021, one hour of work still affords you more than one ticket to the cinema. Your wages have kept up with inflation, and your purchasing power (at least for movie tickets) remains the same. 

Factors that affect purchasing power

The example of the movie tickets above is greatly simplified, and there are many other factors at play in real life.

Economic conditions

Economic conditions refer to the overall state of the economy, including factors such as employment, GDP growth and consumer confidence. All of these can affect purchasing power by driving prices up or down, impacting supply and demand or making credit more expensive. Individuals have very little control over most of these conditions. It is, however, important to be aware of them, so you can make educated decisions on your spending, investments and savings. 

Inflation

Inflation refers to the rate at which prices for goods and services are increasing. As prices increase, purchasing power decreases — especially if income doesn’t increase overall at the same rate. Again, individuals don't have any control over inflation. But based on what's happening in the overall economy, you can make smart decisions, such as negotiating a raise, securing a second job or side hustle, or looking into passive income strategies

Interest rates

Interest rates refer to the cost of borrowing or the return on savings and investments. Both of these can impact purchasing power. The first can increase or decrease the cost of credit, making it harder or easier to get credit that can be used to make purchases. The second impacts how much you earn from your investments, which can increase or decrease your income.

Exchange rates

Exchange rates refer to the value of one currency relative to another. This can affect purchasing power when buying goods or services from other countries. While individuals may not purchase from other countries, the increased prices related to exchange rates can trickle down through manufacturers, wholesalers and retailers, raising the cost of the eventual end product. 

Income

Income refers to the amount of money an individual or household earns. Obviously, how much you make directly impacts your ability to purchase goods and services. This is one of the few factors on this list that you have some control over.

Using CPI to measure purchasing power

The Consumer Price Index (CPI)2 is a measure of the average change in prices of goods and services that households consume over time. It's one of the most common economic indicators used to track inflation in specific economies.

CPI measures the prices of a fixed basket of goods and services, including food, housing, transportation and medical care. The index is calculated by taking the price changes of these goods and services over time and weighting them according to the relative importance of each item in the basket. Note that the CPI isn't the only index of this type, but because it takes into account goods and services necessary for most consumers, it's a good basis for measuring purchasing power.

The CPI indicates how much money is required to purchase the same basket of goods and services at various times — for example, how many of those items you could buy with $100 in 1985 versus how much $100 would get you now. The basic premise works the same as the movie ticket example, except the CPI looks holistically at items and services most people need to purchase regularly. 

If CPI increases, it's an indicator that the cost of living has gone up and purchasing power, in general, has gone down. If deflation occurs and prices go down, the CPI goes down. That means the cost of living also goes down and purchasing power goes up.

Governments and other agencies keep a close watch on the CPI and other such measures of economic health and purchasing power. Sometimes, agencies such as the Federal Reserve3 take action to raise, lower or maintain interest rates to help protect purchasing power — such as when supply and demand issues might otherwise skyrocket prices and create untenable economic situations for families and individuals. 

Purchasing power loss and gain

Loss and gain refer to how changes in the value of money impact the ability of consumers to purchase goods and services. A loss of purchasing power occurs when the value of money relative to costs decreases over time. This means the same amount of money can buy fewer goods and services than before. A gain in purchasing power occurs when the opposite happens, and the same amount of money can buy more goods and services than before.

For example, a household might have a total monthly income of $4,000. They can cover a certain amount of bills, goods and services with that income.

If the cost of living in their area increases by 10% due to inflation, the household may need $400 more dollars to cover the same amount of bills, goods and services. In this case, the household has experienced a loss of purchasing power. Either they need more money to live at the same level, or they must cut out some of their purchases.

On the other hand, if the cost of living decreases by 10%, the household would only need to spend $3,600 to purchase the same basket of goods and services they were able to purchase before for $4,000. In this case, they have experienced a gain in purchasing power.

Our take

Individuals have very little control over major economic factors, including supply and demand, cost of overall goods or exchange rates. That means throughout your lifetime, your purchasing power will go up and down, regardless of what you do.

However, you do have control over how you prepare for times of decreased purchasing power. For example, you know that there may come a time when your wages buy less than they did before. One way to mitigate that purchasing power risk is to maintain a long-term diversified investment portfolio and save money in a high-yield cash account. That way, when inflation causes the cost of goods to rise, you don't have to wait for your wages to catch up. You have investments for your long-term goals and money set aside to help cover some of those increases.

1 Statistica, “Average ticket price at movie theaters in the United States from 2001 to 2021,” January 2023.

2 U.S. Bureau of Labor Statistics, “Consumer Price Index,” 2023.

3 Federal Reserve, “Board of Governors of the Federal Reserve System,” 2023.

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The Currency editors

Staff contributors

The CurrencyTM, a publication from Empower, covers the latest financial news and views shaping how we live, work, and play. We keep you current on ways to plan, save, and invest for life.

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