Understanding Purchasing Power and the Consumer Price Index

What Is 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. It can weaken over time due to inflation. That's because rising prices effectively decrease the number of goods or services that one unit of money can buy. Purchasing power is also known as a currency's buying power.

In investment terms, purchasing or buying power is the dollar amount of credit available to a customer based on the existing marginable securities in the customer's brokerage account.

Understanding Purchasing Power

Purchasing power affects every aspect of economics, from consumers buying goods to investors buying stock to a country’s economic prosperity.

Inflation reduces a currency's purchasing power. Similarly, loss of purchasing power has the same effect of an increase in prices. To measure purchasing power in the traditional economic sense, you could compare the price of a good or service against a price index such as the Consumer Price Index (CPI).

One way to think understand purchasing power is to imagine that you worked the same job that your grandfather worked 40 years ago. Today, you would need a much higher salary to maintain the same quality of living. By the same token, a homebuyer looking for homes 10 years ago in the $300,000 to $350,000 price range had more and better options to consider than people have now in the same price range.

When a currency’s purchasing power decreases due to excessive inflation, serious negative economic consequences can arise. These can include a higher cost of living, higher interest rates that affect the global market, and falling credit ratings. All of these factors can contribute to an economic crisis.

Purchasing Power and CPI

Governments institute policies and regulations to protect a currency’s purchasing power and keep an economy healthy. They also monitor economic data to stay on top of changing conditions. For example, the U.S. Bureau of Labor Statistics (BLS) measures price changes and announces those changes with CPI.

CPI is one of the measures of inflation and purchasing power. It calculates the change in the weighted average of prices of consumer goods and services, and in particular, transportation, food, and medical care, at a given time. CPI can point to changes in the cost of living as well as deflation.

The CPI is just one official measure of purchasing power in the U.S.

Purchasing Price Parity

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

The World Bank's International Comparison Program releases data on purchasing power parities between different countries.

Purchasing Power Loss or Gain

Purchasing power loss or gain refers to the decrease or increase in how much consumers can buy with a given amount of money. Consumers lose purchasing power when prices increase. They gain purchasing power when prices decrease.

Causes of purchasing power loss can include government regulations, inflation, and natural and human-made disasters. Causes of purchasing power gain include deflation and technological innovation.

One example of purchasing power gain would be if laptop computers that cost $1,000 two years ago cost $500 today. In the absence of inflation, $1,000 will now buy a laptop plus an additional $500 worth of goods.

Examples of Purchasing Power Loss

Germany After WWI

Historical examples of severe inflation and hyperinflation—which can destroy a currency’s purchasing power—show us the various causes and effects of such phenomena. Sometimes, expensive and devastating wars will cause an economic collapse, in particular for the losing country. This happened to Germany after World War I (WWI).

In the aftermath of WWI during the 1920s, Germany experienced extreme economic hardship and almost unprecedented hyperinflation, due in part to the enormous amount of reparations Germany had to pay.

Unable to pay these reparations with the suspect German mark, Germany printed paper notes to buy foreign currencies, resulting in high inflation rates that rendered the German mark valueless with a nonexistent purchasing power.

The 2008 Financial Crisis

The effects of the loss of purchasing power in the aftermaths of the 2008 global financial crisis and the European sovereign debt crisis are remembered to this day. Due to increased globalization and the introduction of the euro, currencies are inextricably linked and economic trouble can cross geographic boundaries. As a result, governments worldwide 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 (QE). Quantitative easing, initially controversial, saw the U.S. Federal Reserve System (Fed) buy government and other market securities to increase the money supply and lower interest rates.

The increase in capital spurred increased lending and created more liquidity. The U.S. stopped its policy of quantitative easing once the economy stabilized.

The European Central Bank (ECB) also pursued quantitative easing to help stop deflation in the eurozone after the European sovereign debt crisis and bolster the euro's purchasing power. The European Economic and Monetary Union established strict regulations in the eurozone related to accurately reporting sovereign debt, inflation, and other financial data.

As a general rule, countries attempt to keep inflation fixed at a rate of 2%. Moderate levels of inflation are acceptable. High levels of deflation can lead to economic stagnation.

Special Considerations

Investments That Protect Against Purchasing Power Risk

Retirees can be particularly aware of purchasing power loss since many of them live off of a fixed amount of money. They must make sure that their investments earn a rate of return equal to or greater than the rate of inflation so that the value of their nest egg does not decrease each year.

Debt securities and investments with fixed rates of returns are the most susceptible to purchasing power risk or inflation. Fixed annuities, certificates of deposit (CDs), and Treasury bonds all fall into this category. For instance, a long-term bond with a low fixed rate of return might fail to increase your investment during periods of inflation.

Some investments or investing strategies can help protect investors against purchasing power risk. For example, Treasury inflation-protected securities (TIPS) adjust to keep up with rising prices. Commodities such as oil and metals may maintain pricing power during periods of inflation.

The Bottom Line

Long-time investors know that loss of purchasing power can greatly impact their investments. Rising inflation affects purchasing power by decreasing the number of goods or services you can purchase with your money.

Investors must look for ways to make a return higher than the current rate of inflation. More advanced investors may track international economies for the potential effect on their long-term investments.