Purchasing power measures the amount of goods or services a currency can buy. Understanding and protecting your purchasing power from negative effects such as inflation is an important part of effectively planning your personal finances through budgeting, spending and savings.
- Written By Terry Turner
Senior Financial Writer and Financial Wellness Facilitator
Terry Turner is a senior financial writer for Annuity.org. He holds a financial wellness facilitator certificate from the Foundation for Financial Wellness and the National Wellness Institute, and he is an active member of the Association for Financial Counseling & Planning Education (AFCPE®).Read More
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- Financially Reviewed ByStephen Kates, CFP®
Stephen Kates, CFP®
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- Updated: January 30, 2023
- 6 min read time
- This page features 4 Cited Research Articles
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What Is 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.
What Does Purchasing Power Parity Mean?
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 greatly impacts how well-off you feel. Although wage growth has increased recently, inflation has reduced the value of the dollar and reduced the amount of goods that can be purchased. Negative purchasing power can be most readily felt with the rising costs of everyday purchases like gas or groceries."
Why Does Purchasing Power Matter?
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.
What Factors Affect Purchasing Power?
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).
- Changes in Wages
- Employment levels and average salary levels have huge impacts on purchasing power. Higher employment means more money earned and higher demand for goods and services. Employment and wages do not impact the value of a currency, but increase the amount of money available to consumers, leading to higher commercial and tax revenues.
- Supply and Demand
- Supply and demand refers to the amount of goods or services supplied by companies versus the demand for goods or services by consumers. If companies produce more goods or services than are purchased, supply increases and reductions in prices often occur, increasing purchasing power. Demand that is higher than the available supply of goods or services has the opposite effect — prices go up, which decreases purchasing power since more dollars must be spent to purchase goods or services.
- Interest Rates
- The availability of credit for consumers and businesses affects the purchasing power in almost the same way that higher wages do. With money from loans, customers and businesses can spend more, boosting personal purchasing power. Lenders earn interest from these loans, providing them with more money to spend. The interest charged by lenders also affects purchasing power. When the interest charged goes up, consumers and businesses are less likely to borrow money, driving down demand.
- Often defined as “too many dollars chasing too few goods,” inflation increases consumer prices and reduces overall consumer purchasing power. Savings and fixed incomes are particularly hard hit by this phenomenon. For example, retirees risk losing purchasing power and face negative effects on their standard of living as time passes and the cost of goods and services goes up.
How Does Inflation Influence Purchasing Power?
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.
Protecting Your Purchasing Power
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.
- Examine Your Spending
- Where are you spending your money every month? How much of that is discretionary spending (such as money not spent on basic, necessary expenses)? Consider where you can cut back on entertainment or travel spending. For those necessary expenses like food and medicine, buy more house or generic brands, and use coupons and store loyalty programs where possible. For those necessary big-ticket items like vehicles or appliances, it might be wise to buy now as prices will likely rise if you wait.
- Save on Recurring Fees
- Look for savings in your subscriptions and service fees. Call your cable or cell phone provider and ask for a better plan. Negotiate with your bank or credit card companies to eliminate monthly or annual service fees, or switch to accounts that don’t have any. Cut back the number of subscriptions you have, as their prices often climb quietly without you noticing.
- Bring in More Money
- Small moves like switching to high-yield savings accounts at your bank or credit union can help. When was the last time you asked for a raise? If you’re not getting cost-of-living increases to keep up with inflation, it amounts to a pay cut over time. In the wake of the Great Resignation, it’s a seller’s market for labor — there might never be a better time to leverage a tight job market for a worthwhile raise.
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.”
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4 Cited Research Articles
Annuity.org writers adhere to strict sourcing guidelines and use only credible sources of information, including authoritative financial publications, academic organizations, peer-reviewed journals, highly regarded nonprofit organizations, government reports, court records and interviews with qualified experts. You can read more about our commitment to accuracy, fairness and transparency in our editorial guidelines.
- Cambridge Dictionary. (n.d.). Purchasing Power. Retrieved from https://dictionary.cambridge.org/dictionary/english/purchasing-power
- Cambridge Dictionary. (n.d.). Spending Power. Retrieved from https://dictionary.cambridge.org/dictionary/english/spending-power
- Organization for Economic Co-operation and Development. (n.d.). Purchasing Power Parities. Retrieved from https://data.oecd.org/conversion/purchasing-power-parities-ppp.htm
- Statista. (n.d.). Monthly 12-Month Inflation Rate in the United States From January 2020 to August 2022. Retrieved from https://www.statista.com/statistics/273418/unadjusted-monthly-inflation-rate-in-the-us/
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