The recent price hikes have probably affected your wallet, both at work and at home.
Essentials like food rose about 17% from 2020 to 2022, while gasoline more than doubled to almost $5 a gallon. Understanding what’s behind these fluctuations is crucial, as they indicate shifts in your purchasing power.
Here’s what you need to know about purchasing power, and what it means for individuals as well as small business owners.
What is purchasing power?
Purchasing power is a term for how much material goods your money can buy at a given time—or the bang for your buck, so to speak. Inflation (the sustained increase in prices over a given time) affects purchasing power, and the two move inversely. For example, if consumer price inflation was 5% in the past year, that means purchasing power declined by 5%.
Purchasing power and inflation influence the cost and standard of living, affecting how much you pay for the things that maintain your lifestyle. This includes housing, transportation, food, fuel, health care, and entertainment.
Economists and public policymakers watch inflation to see if it’s accelerating, slowing down, or even reversing to the point where prices fall (deflation). Central banks, such as the Federal Reserve in the US, analyze inflation trends to set benchmark interest rates, as part of their mission to promote economic growth while preserving the currency’s purchasing power.
A brief history of purchasing power in the economy
In your everyday life, you may track inflation and purchasing power for particular things—a gallon of gasoline or a pound of ground beef, for example. But governments and economists track inflation through indexes, based on baskets (a representative collection of many goods and services). They use inflation indexes to gauge the degree of price changes throughout an economy.
The idea of purchasing power is central to the economic well-being of a nation. As prices go up and the purchasing power of currency goes down, people can buy less with one unit of currency than they could before. To maintain their lifestyle, individuals need to earn more. When Congress created the Federal Reserve in 1913, the central banks’ two primary objectives, known as the dual mandate, were to promote maximum employment and price stability.
Stable prices mean low inflation, so the purchasing power of Americans isn’t eroded. The Federal Reserve’s target for price stability is to hold inflation to 2%, which it considers sustainable. This means consumers can adapt to the small amount of inflation and maintain purchasing power.
Indexes used to track inflation
Many kinds of indexes track inflation in different countries and regions. In the US, economists most commonly look at the following as barometers of changing prices:
Consumer Price Index (CPI)
This is the most frequently used reference for inflation because consumer spending accounts for two-thirds of the US economy. The Census Bureau conducts the Consumer Expenditure Survey (CE) for the Bureau of Labor Statistics (BLS), surveying prices on about 80,000 goods and services and focusing on consumers in urban areas.
Personal Consumption Expenditures Price Index (PCE)
The Federal Reserve prefers PCE as a more accurate inflation gauge because it covers a broader range of goods and services and includes rural consumers. Also, the PCE updates the proportionate weights of spending categories more frequently to reflect shifts in consumer spending behavior. The PCE index generally tracks closely with CPI but is sometimes more muted; for example, when the CPI peaked at 9% in mid-2022, PCE was roughly 7%.
Producer Price Index (PPI)
While the other indexes focus on the prices consumers pay, PPI tracks changes in prices received by producers of goods and services at the wholesale level. Economists view the PPI as a possible predictor of CPI changes because wholesale prices precede the final prices consumers pay.
Key factors in purchasing power
Purchasing power refers to how much you can buy at a given time. Some key factors that affect purchasing power include:
Inflation and deflation
Changing prices are the most important determinant of purchasing power. Inflation erodes the power, while deflation (such as during the 2008 financial crisis and the years following World War I) increases it. The formula to calculate the rate of inflation looks at the difference between the starting and ending values of CPI. The formula looks like this:
Inflation rate = (Ending CPI - Starting CPI) / Starting CPI x 100
For example, let’s say the CPI had a value of 100 and rose to 10. The rate of inflation would be:
(107 - 100) / 100 x 100 = 7%
Because purchasing power moves inversely to inflation, a 7% inflation rate means a dollar’s purchasing power is down to 93¢ compared to the year before.
Income
Growth in household or business income does not necessarily mean more purchasing power. For example, say inflation was 3% in the past year. If your total income such as wages, rent, and investment income also increased by 3%, your purchasing power remained steady and you could buy the same amount of goods and services.
On the other hand, if inflation was 7% while your income grew only 3%, you’d have less purchasing power. If your income grew by 7% and inflation only rose by 3%, then you gained more purchasing power.
Interest rates
The level of interest rates can influence economic growth and inflation by encouraging or discouraging borrowing that funds consumer and business purchases. Central banks try to balance economic growth with restrained inflation by guiding interest rates higher or lower.
A key example of interest rates affecting our purchasing power is housing—particularly home mortgages. Housing costs account for more than a third of the CPI. During 2020 and the COVID-induced economic slowdown, a borrower with good credit could get a mortgage with a 3.5% interest rate. Since then, mortgage rates have almost doubled, increasing monthly payments.
Money supply
In economic terms, a nation’s money supply is the total of all cash and cash equivalents circulating in the economy at a given time. In effect, it’s a gauge of the funds available among banks for potential loans to households and businesses. In the US, the Federal Reserve influences the money supply by taking actions that either expand the supply to encourage economic growth (easing) or restrict the supply to keep growth from overheating and leading to price inflation (tightening).
Some ways to maintain purchasing power now and in the future could include:
- Increasing income (wages for households, sales for businesses)
- Investing in financial assets that have higher average long-term returns, such as stocks
- Finding cheaper substitutes among goods and services, such as supermarket-brand groceries instead of brand-name products
- Buying in bulk to lower average costs
- Creating and maintaining a budget
Business owners can also negotiate discounts or other concessions from suppliers, or start or join buying cooperatives to improve their purchasing power compared with big companies.
What is purchasing power parity?
While purchasing power mainly focuses on the value of a nation’s currency in domestic transactions, it’s also pertinent when buying goods or services in foreign countries. This makes it important to understand the dollar’s value relative to other currencies. This is where purchasing power parity (PPP) comes in.
The theory of PPP is that goods and services should cost the same in any country or region after factoring in currency exchange rates. Converting foreign currencies to a reference currency—typically the US dollar—makes it possible to fairly compare the purchasing power of countries.
🌟Resource: International Ecommerce: How To Sell Globally Online
Calculating purchasing power parity involves the implied exchange rate for two currencies. The implied rate may differ from the actual exchange rate in currency markets because of different inflation rates among countries, trade tariffs, and other factors. Still, it can be useful in getting a sense of relative purchasing power.
The formula for the implied exchange rate looks like this:
Implied exchange rate = price of basket of goods in currency A / price of basket of goods in currency B
Let’s use an example of a hypothetical basket of consumer goods and services, priced at $500 in the US, and €400 in Germany. The implied exchange rate would be:
$500 / €400 = $1.25 per euro
This means an exchange rate of $1.25 per euro would produce purchasing power parity.
A different real exchange rate would give one currency more or less purchasing power. A $1.10-per-euro rate makes the dollar relatively stronger, for example, while a $1.50-per-euro rate makes the euro relatively stronger.
Purchasing power FAQ
What is an example of purchasing power?
Among the most current and prevalent examples of purchasing power are tracking the price of fuel for cars and the price of food and groceries. The price of unleaded regular gasoline rising from $2 a gallon to $3.50 represents a loss of purchasing power when you’re filling your car’s fuel tank.
What is the purchasing power of a dollar?
The purchasing power of a dollar is its value in obtaining a certain quantity of products and services. Inflation erodes that purchasing power. If inflation rose at a 5% rate in the latest year, for instance, the dollar’s purchasing power declined 5%, to 95¢.
How do you determine your purchasing power?
The rate of price inflation primarily determines purchasing power. If the Consumer Price Index rose at a 5% annual rate, for example, your purchasing power declined by 5%. One way to offset a loss of purchasing power is to increase your income from wages or other sources.
