What is Purchasing Power?
Purchasing power may be a confusing term for some. Often, people think in terms of how their purchases are consequently boosting brands and their favorite businesses when they buy from them. Purchasing power, however, does not mean this. What purchasing power equates to rather is how much buying power you have given several factors — inflation foremost among them. In this article, we look at what exactly purchasing power means and how inflation comes to impact someone’s purchasing power.
Understanding purchasing power
As noted, purchasing power refers to how much your money can buy given a conflation of factors at a certain period. That said if prices rise you are going to have less purchasing power. And when prices drop, that inevitably increases the amount of purchasing power you have. This is why when discussing purchasing power, you also have to look at the impact of inflation.
Over time, what you can buy with a dollar is going to change. Think about where things stood ten years ago — prices were lower on many items. At the same time, however, ten years ago people did not make as much as they do today. Generally speaking, prices and salaries increase together in a mutually dependent way. There are however times when salaries don’t rise as rapidly as market prices; this is when people experience inflation. And then essentially what happens is that your purchasing power will decrease because while products and services cost more, your paycheck hasn’t risen in tandem with prices. You can’t afford to buy as much as you once could.
Inflation is tracked monthly in this country using the Consumer Price Index. On all items — clothing to food and everything in between — the average cost and the difference in that cost from one month to the next is used to determine where we are in terms of inflation and the potential therein. By understanding how much inflation there is and knowing where your salary stands about any inflation, you thus have a better handle on your purchasing power at that given time.
Why does purchasing power matter?
Beyond signifying what someone can get with how much money they have, purchasing power can also influence stock prices to some extent. With inflation, as we have seen, purchasing power decreases. This, in turn, can have a pretty big impact on the stock market. As the cost of living goes up there are times when consumers don’t have the same purchasing power because their income hasn’t followed suit. There is less money circulating in the economy. Companies, therefore, feel the pinch, and stock prices could potentially fall.
Interest rate changes can also affect someone’s purchasing power. If let’s say your interest rate decreases, this means that your monthly payment will also decrease. You now do have more money to help you keep up with any relevant inflation. The same goes with mortgage rates for instance. If you experience a mortgage rate decrease at some point during the life of your loan, this will positively impact your monthly payment — meaning, those payments will decrease. As such, you now have greater purchasing power.
Another important factor to consider as far as purchasing power goes is that which occurs between the two countries. In other words, exchange rates come into play here. One country’s currency may be worth quite a bit more than another’s. This, in turn, gives individuals from the country with the more valuable currency more purchasing power in the country with the less valuable currency. And of course, the opposite scenario applies as well with the country whose currency is less valuable having decreased purchasing power in the country whose currency amounts to more.
Purchasing power and investments
Purchasing power will have an impact on a person’s investments. If there is significant inflation, what you initially invested will come to be less over time. This means that if it is during a period of inflation and you go to use that money you invested, it will equate to less purchasing power as the investment is now of a lesser value. This is why investors spend so much time studying the various rates of return on potential investments; they want to make sure that that rate is more than the value of inflation over the long run. With any investment, you need to look carefully at the amount of time you plan for that investment in conjunction with your overall risk tolerance.
The longer you have as far as a time horizon, the more time you are allotting for any stock market recovery if stock prices do take a hit and your purchasing power in association with this decreases.
One thing to keep in mind is that it is often better to start investing sooner rather than later. Compounded interest accrues on your investments and this means that as your account earns interest the value of that account could theoretically grow quite substantially over time. Rule of thumb tends toward having a fairly diverse portfolio possessing both riskier investments such as stocks mixed with more conservative securities such as bonds and mutual funds for example.
When investing, obviously the goal is to gain wealth so that the money is there for future use when you need it. To this end, understanding inflation and how it comes to affects purchasing power can be helpful in terms of enabling you to make smarter investment decisions.
