Purchasing power is the value of money in terms of the amount of goods and services it can buy. Because purchasing power can impact everything from consumer spending to stock prices and currency exchange rates, it can be an indicator of current economic conditions.
Purchasing power can also be described as "buying power." It measures how much you can buy with a unit of currency, such as a dollar.
The purchasing power of a dollar (or other currency) typically decreases over time as the prices on goods and services rise. For example, if you used to buy a tank of gas for $20 and you now pay $50 for the same tank of gas, your purchasing power has decreased.
Because purchasing power affects every part of the economy, governments track and measure it to keep tabs on their economy's health. They also institute policies to influence purchasing power and try to maintain a strong economy.
The consumer price index (CPI) is one way to measure inflation and purchasing power. In the United States, the Bureau of Labor Statistics keeps track of changes in the price of goods and publicizes those changes through the CPI.
The consumer price index regularly tracks the average prices of a market basket of goods purchased by consumer households. The basket includes common household purchases like transportation, housing, food and medical care. CPI is expressed as a percentage in comparison to the previous month. For example, the U.S. consumer price index increased 5% between March 2022 and March 2023, according to the Bureau of Labor Statistics.
Purchasing power parity (PPP) measures purchasing power across different currencies in different countries. It assumes that purchasing power should be equal in various currencies at the same time. Basically, with PPP, one U.S. dollar would be able to buy the same amount of goods anywhere in the world, once converted to the local currency.
For example, if a bottle of soda costs $1 in the U.S. and 2 euros in France, the market exchange rate from the dollar to the euro would be 1:2. That assumes complete purchasing power parity between the two countries.
While PPP may be an ideal economic theory, it doesn't actually impact currency exchange rates. Instead, exchange rates are determined by supply and demand in the currency markets. Rather than a determinant of exchange rates, PPP is just a method of comparison for currencies, in terms of the goods and services they can purchase.
Economists use the PPP theory to compare a basket of goods in one currency to that of another, after accounting for exchange rates. The PPP is essentially the exchange rate at which one country's currency would have to be converted to the currency of another country in order to buy the same amount of goods and services. So if a foreign currency's value goes up against the dollar, that can affect an American's purchasing power in that country.
Purchasing power directly affects the amount of goods and services that money can buy. It also affects stock prices and general economic health. That's because if the buying power of a dollar decreases significantly, and it costs more to handle everyday expenses, more consumers will become cash-strapped. In turn, the health of the economy will drop.
One item that has a big impact on purchasing power is the current interest rate. When interest rates rise, purchasing power drops. For example, mortgage rates reached historic lows in 2021. A person who purchased a new home in that year may have secured a mortgage with an interest rate of 3%.
Two years later, after aggressive rate hikes by the Federal Reserve, the same homebuyer may get a mortgage interest rate of 7%. That increased interest rate would significantly deplete the homebuyer's purchasing power. To achieve the same monthly payment the person got in 2021, they'd have to buy a much less expensive home in 2023 to account for the higher interest rate.
Inflation, a broad rise in the cost of goods and services over time, erodes purchasing power. As prices increase, purchasing power decreases, and dollars won't stretch as far.
Consider the annual salary a middle-income household earned in 1983. It may have paid for the mortgage on a home in the suburbs, weekly groceries and a vacation once a year. Four decades later, a family would have to earn almost three times as much to pay for the same home, groceries and annual vacation. That's an example of declining purchasing power over time, as the result of inflation.
Historically, significant changes in purchasing power have been a part of long-lasting economic shifts. For example, the Great Recession, a global period of general economic decline, occurred from 2007 to 2009. Accompanied by increased unemployment and prolonged inflation, the Great Recession was marked by a deep decrease in purchasing power.
As a result of decreased purchasing power, research shows that consumer spending decreased substantially. One area in which people spent significantly less was dining out. Data from the U.S. Department of Agriculture's Economic Research Service shows that spending on food consumed away from home declined by 11.5% from 2006 to 2009.
A shift in purchasing power doesn't just affect how much you can purchase in real goods, such as restaurant meals and groceries. Decreased purchasing power also can erode the purchasing power of your investments because when you cash out, the money you invested will be worth less.
Because of the risk of a drop in purchasing power, it's important to focus on investments that will earn a rate of return that is greater than the value of inflation. When deciding where to invest, consider factors such as your investment objective, time horizon, and risk tolerance. If you have a longer time horizon, your investments will have more time to recover, even if they suffer from a dip in purchasing power.
With an automated investing account like Acorns Invest, you can continually invest — even with amounts as small as your spare change. Over time, you can take advantage of the investing power of your money, even as the purchasing power of the dollar moves up and down.
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