What is Purchasing Power? (2024)

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• Purchasing power refers to how much you can buy with a unit of currency, such as a dollar.
• If your purchasing power declines, your money has become less valuable.
• 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?

Defining purchasing power

Purchasing 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 U.S. dollar (USD).

"Imagine that you make the same salary as you did twenty years ago," says Robert Johnson, who serves as both 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."

A dollar in 1973 had the purchasing power of $6.86 50 years later in 2023, according to data provided by the Federal Reserve Bank of Minneapolis.

What impacts purchasing power?

Inflation: The primary factor

Knowing the effects of inflation on purchasing power is very important to understanding this financial concept. Economists can track changes in purchasing power to better understand how inflation impacts 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.

More specifically, inflation is the increase in the prices of goods and services over time. The Consumer Price Index (CPI) is a commonly used inflation measure. It uses regular 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.

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.

It is also important to be familiar with deflation, a decrease in the price level. While falling prices are more rare than rising prices, deflation did materialize in the U.S. during the Great Depression.

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.

Income

Another major variable that can have a notable impact on purchasing power is income. One good way to quantify this is in terms of changes in "real wages," a measure of changing wages minus inflation. In effect, it's a measure of how a household's purchasing power fluctuates over time.

If your real wages become larger, you will experience increasing purchasing power, and you will be able to buy more than you could before.

Interest rates

Interest rates can also impact purchasing power. One clear example is how much real estate a person can buy. If interest rates increase, it makes it so that an individual buyer can purchase less with the same money.

Another example of how interest rates can impact purchasing power is by the effect they have on production costs. If borrowing costs increase, and companies have to pay more to access capital, it pushes the cost of production higher and can result in more expensive goods and services, and therefore reduced purchasing power.

Other factors

Your individual buying power can also be influenced by other factors, including government and manufacturers' policies.

For example, a new government regulation could impact an entire industry and lead to changing prices for goods and services in that sector. Alternatively, a new technology could increase manufacturing efficiency, decreasing the cost of certain products.

Past that, local tax rates could have a significant impact on basic expenses. More specifically, 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.

Why purchasing power matters

Affects standard of living

The clearest way that purchasing power can impact you is by influencing your standard of living. If the purchasing power of your money declines, you will not be able to afford as much as you could before, meaning you will have less ability to buy the goods and services you need.

Such a shift could make a big difference if declining purchasing power negatively impacts your ability to pay for basic expenses like housing and groceries.

Impacts savings

If the purchasing power of the money (or assets) you have saved declines, it reduces the amount of goods and services you could purchase with those resources. This could have a substantial impact on someone (for example, a retiree) who is relying on their savings to pay their living expenses.

There are some specific things you should keep in mind when trying to determine your future purchasing 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.

Influences investment decisions

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 circ*mstances. In a way, this makes these tools purchasing power calculators.

Another consideration is that you could potentially put your money into assets that come with higher risk, but provide a greater expected return, to ensure that you can keep up as prices push higher.

If you anticipate substantial inflation, you might feel more motivated to buy stocks, for example, instead of putting your money into fixed-income instruments like bonds that have lower expected returns.

Purchasing power: Conclusion

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.

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