Purchasing Power

Purchasing power refers to the value of a currency based on the amount of goods or services it can buy. The value of a single unit of currency — such as $1 — is the purchasing power of that currency.

Your purchasing power can fluctuate over time because of factors like inflation, changing interest rates and income fluctuations. Because managing your finances involves long-term planning and considering potential financial risks, understanding your purchasing power is an important part of effectively planning your personal finances.

A related term is spending power, sometimes called “buying power.” Spending power refers to how much money people have available after taxes to buy products and services, but not the overall purchasing power of the currency. The two terms should not be confused and aren’t interchangeable.

Purchasing power parity (PPP) is an analysis metric comparing economic productivity and standards of living between countries. This is done by trying to equalize the rates of currency conversion and the purchasing power of different currencies.

PPP uses a “basket of goods” from each country as the benchmark for comparison. These goods and services include final consumption of households and government, fixed capital formation and net exports measured in U.S. dollars.

Purchasing power matters because of the impact it has on your personal finances. While the macro factors that affect the purchasing power of a currency are out of the hands of ordinary people, it is ordinary people who feel the changes in purchasing power most directly.

It’s no secret that what you can buy for $100 today is far less than what $100 would’ve gotten you 20 years ago. That loss of purchasing power is, in effect, a price increase on goods and services — your dollars don’t go as far as they used to.

For example, in 1944, one U.S. dollar would buy 20 bottles of Coca-Cola. Today, that same $1 would get you a single small coffee at a fast-food restaurant.

Failing to protect your purchasing power now could have negative impacts on your finances down the road. For example, eroding purchasing power can mean investments that won’t be worth as much in the future, the cost of your lifestyle creeping upward and an increased risk of outspending your savings.

Microeconomic factors (factors that directly impact individuals and companies, like supply and demand or taxation) can affect purchasing power, as can macroeconomic factors (factors that impact the economy as a whole, such as inflation and interest rates).

Rising prices due to inflation decrease the amount of goods or services you can buy at current income levels. This is the chief negative of inflation and its main drag on purchasing power.

While inflation is always part of the economy, it fluctuates up and down, especially due to the effects of supply and demand. To maintain the purchasing power of consumers, inflation must be countered by businesses and central banks through measures like higher wages and interest rate adjustments.

In 2022 alone, interest rates in the United States have hit 40-year highs. By August 2022, prices had increased 8.3% from just a year earlier, impacting the purchasing power of every American.

Because inflation is always part of the economy, governments and banks try to keep the rate of inflation within an optimal range that allows for growth while not adversely affecting the purchasing power of consumers. The Federal Reserve, for example, will raise or lower interest rates to restrict or expand the flow of money within the economy to keep inflation to what it deems an acceptable level.

Ultimately, the best defense against inflation is living within your means in good times and bad.

“One of the great defenses to being worried about inflation is not having a lot of silly needs in your life,” says Charlie Munger, vice chairman of Berkshire Hathaway and Warren Buffett’s business partner. “If you haven’t created a lot of artificial demand to drown in consumer goods, you have a considerable defense against the vicissitudes of life.”