Purchasing Power

Purchasing power refers to the number of commodities that can be purchased with a certain amount of money. It is affected by inflation, which is the general increase in prices of commodities over time. It aims to measure the value of money in terms of what it can buy.

It aims to understand the relative value of money at different points in time or other countries or regions. It helps to know how much money one needs to purchase a particular item at a specific time. A currency with a high purchasing capacity can buy more goods and services than a currency with a low purchasing capacity.

• Purchasing power refers to the number of goods or services purchased with a given amount. It is affected by factors such as inflation, interest rates, and exchange rates.
• Inflation is one of the most significant factors that affect purchasing power index. When inflation is high, the purchasing capacity of money decreases, meaning that the same amount of money can buy fewer goods or services.
• It can be measured using price indexes such as the Consumer Price Index (CPI) or the Producer Price Index (PPI).

Purchasing power reflects the overall level of prices in an economy and the availability of goods and services. Suppose the general level of prices in an economy increases. In that case, the purchasing capacity of a given amount of money will decrease, and it will be able to buy fewer goods and services. Conversely, if the overall level of prices in an economy falls, then the purchasing capacity of a given amount of money will increase, and it will be able to buy more goods and services. Factors such as inflation and deflation can also affect purchasing capacity.

It is also the result of factors such as interest and exchange rates. Similarly, when interest rates are high, the cost of borrowing money increases, which can also decrease purchasing capacity. Exchange rates also play a role in purchasing power parity, as a stable domestic currency can increase purchasing capacity when traveling abroad. Overall, it measures the value of money in terms of the goods and services it can buy.

The most common method of calculating it is the Consumer Price Index (CPI), which measures the average change in prices over time of a basket of goods and services consumed by households. For example, to calculate it, one would need the following information:

1. The current CPI measures the average price change of household goods and services.
2. The base year CPI is a reference point to measure the average price change of a basket of goods and services consumed by households in a specific year.
3. The amount of money in question is the amount one wants to calculate the purchasing power risk.

One can calculate it using the following formula:

Purchasing power = (amount of money / (current CPI/ base year CPI)) x 100

This formula shows the number of goods and services that come with the given amount of money based on the average prices in the base year.

Several factors can affect purchasing power:

1. Inflation: It increases an economy's overall price of goods and services. When inflation is high, the purchasing capacity of money decreases, meaning that the same amount of money can buy fewer goods or services. This occurs because as the prices of goods and services increase, the same amount of money can buy less.
2. Interest Rates: Interest rates are the cost of borrowing money. When interest rates are high, the cost of borrowing money increases, which can decrease purchasing capacity. This occurs because borrowing money increases, and people have less money to spend on goods and services, reducing purchasing capacity.
3. Exchange Rates: Exchange rates are the value of one currency about another. A robust domestic currency can increase purchasing power by when traveling abroad. This happens because when the domestic currency is strong, it can buy more foreign currency, allowing people to buy more goods and services when traveling abroad.
4. Employment And Wages: Employment and wages are closely related to purchasing capacity. When employment is high and wages rise, people have more money to spend, which can increase purchasing capacity.
5. Government Policies: Government policies, such as taxes, subsidies, and regulations, can also affect purchasing capacity. For example, suppose tariffs on specific goods or services escalate. In that case, the price of those goods or services will increase, decreasing purchasing capacity.
6. Supply And Demand: The availability and popularity of goods and services can also affect purchasing capacity. When demand for a commodity is high and the collection is little, prices will rise, decreasing purchasing capacity.
7. Economic Growth: Economic growth can also affect purchasing capacity. When the economy grows, there is more demand for goods and services, leading to higher prices and lower purchasing capacity.

All these factors are similar, and their effect on purchasing power by country can vary depending on the specific context and period.

Let us understand the concept in the following purchasing power examples -

Example #1

An example is comparing the cost of goods and services from one year to another. Suppose in 2000, a basket of goods and services that cost $100 would include a gallon of gas for $1.50, a loaf of bread for $1.00, and a new car for $15,000.

In 2020, the same basket of goods and services would cost $300. For example, a gallon of gas would cost $2.50, a loaf of bread would cost $3.00, and a new car would cost $30,000.

In this example, the purchasing power of $100 in 2000 is much greater than that of $100 in 2020. This is because, in 2000, $100 could buy more goods and services than it could in 2020. This is due to the increase in price levels caused by inflation.

Example #2

In January 2023, Gartner Inc., a leading provider of information technology (IT) market research, decreased its prior projection of a 5.1% increase in global IT expenditure for 2023 to a forecast of 2.4%. The company is expecting to see spending of $4.5 trillion this year. While the prophecy is that overall enterprise IT expenditure will continue to grow, and the downgrading is the result of inflation's ongoing erosion of consumer spending power and device spending.

The former, i.e., buying power and purchasing power are related but distinct concepts. Buying power refers to the ability of a consumer to purchase a commodity, taking into account factors like income, creditworthiness, and access to financing. It is the amount of money a consumer spends on goods and services.

On the other hand, purchasing power refers to the number of goods or services purchased with a given amount. Therefore, it results from factors such as inflation, interest rates, and exchange rates. For example, when inflation is high, the buying power of money decreases. It means that the same money can buy fewer goods or services.

Here, buying power calls for -

• The ability of a consumer to purchase a good or service
• Takes into account income, creditworthiness, and access to financing
• The amount of money that a consumer has available to spend on goods and services

While Purchasing power calls for -

• The affordable commodities with a given amount of money
• Affected by inflation, interest rates, and exchange rates.
• When inflation is high, the purchasing power of money decreases.

Both concepts affect an individual's ability to afford goods and services. However, they measure different aspects of that ability. Purchasing power relates to the economic conditions that affect the value of money.

This has been a guide to Purchasing Power and its meaning. Here, we explain how to calculate it, its example, comparison with buying power, and factors. You can learn more about finance from the following articles –

• Purchasing Power Parity Formula
• Purchasing Power Parity
• Differential Pricing