Understanding purchasing power

Purchasing power is the value of a currency expressed in terms of the number of goods or services that one unit of money can buy. Purchasing power is important because, all else being equal, inflation decreases the number of goods or services you would be able to purchase.

In investment terms, purchasing power is the dollar amount of credit available to a customer to buy additional securities against the existing marginable securities in the brokerage account. Purchasing power may also be known as a currency's buying power.

Purchasing power affects every aspect of economics, from consumers buying goods to investors and stock prices to a country’s economic prosperity. When a currency’s purchasing power decreases due to excessive inflation, serious negative economic consequences arise, including rising costs of goods and services contributing to a high cost of living, as well as high interest rates that affect the global market, and falling credit ratings as a result. All of these factors can contribute to an economic crisis.

As such, a country’s government institutes policies and regulations to protect a currency’s purchasing power and keep an economy healthy. One method to monitor purchasing power is through the Consumer Price Index. The U.S. Bureau of Labor Statistics (BLS) measures the weighted average of prices of consumer goods and services, in particular, transportation, food, and medical care. The CPI is calculated by averaging these price changes and is used as a tool to measure changes in the cost of living, as well as considered a marker for determining rates of inflation and deflation.

A concept related to purchasing power is purchasing price parity (PPP). PPP is an economic theory that estimates the amount that needs to be adjusted to the price of an item, given two countries’ exchange rates, in order for the exchange to match each currency’s purchasing power. PPP can be used to compare countries’ income levels and other relevant economic data concerning the cost of living, or possible rates of inflation and deflation.

Today, the effects of the loss of purchasing power are still felt in the aftermath of the 2008 global financial crisis and the European sovereign debt crisis. With increased globalization and the introduction of the euro, currencies are even more inextricably linked. As such, governments institute policies to control inflation, protect purchasing power, and prevent recessions.

For example, in 2008 the U.S. Federal Reserve kept interest rates near zero and instituted a plan called quantitative easing. Quantitative easing, initially controversial, essentially saw the U.S. Federal Reserve buy government and other market securities to lower interest rates and increase the money supply. The idea is that a market will then experience an increase in capital, which spurs increased lending and liquidity. The U.S. stopped its policy of quantitative easing once the economy stabilized, due in part to the above policy and a multitude of other complex factors.

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