Understanding Purchasing Power and the Consumer Price Index (2023)

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 you 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.

Key Takeaways

  • Purchasing power is the amount of goods or services that a unit of currency can buy at a given point in time.
  • Inflation erodes the purchasing power of a currency over time.
  • Central banks adjust interest rates to try to keep prices stable and maintain purchasing power.
  • One U.S. measure of purchasing power is the Consumer Price Index (CPI).
  • Globalization has linked currencies more closely than ever so protecting purchasing power worldwide is crucial.


(Video) How to Calculate the Consumer Price Index (CPI) and Inflation Rate

What Is Purchasing Power?

Understanding Purchasing Power

Inflation reduces a currency's purchasing power and what that currency can buy. Loss of purchasing power has the 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 about purchasing power is to imagine that you made the same salary that your grandfather made 40 years ago. Today, you would need a much greater 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.

Purchasing power affects every aspect of economics, from consumers buying goodsto investors buying stockto a country’s economic prosperity.

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.

(Video) Consumer Price Index (CPI), Inflation & Interest Rates Explained

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.

The Great Inflation of the 1970s to early 1980s devastated the purchasing power and standard of living of Americans. The rate of inflation skyrocketed to 14%.

Examples of Purchasing Power

Germany After WWI

Historical examples of severe inflation and hyperinflation (which can destroy a currency’s purchasing power) can show us the various causes and effects of such phenomena. Sometimes, expensive and devastating wars will cause an economic collapse, in particular forthe 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.

(Video) CM Notes 24: Inflation Rate & Purchasing Power

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 percent. 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.

(Video) What is CPI (Consumer Price Index) Inflation Data? | Economic Data Explained

What's Purchasing Power?

Purchasing power refers to how much you can buy with your money. As prices rise, your money can buy less. As prices drop, your money can buy more.

How Does Inflation Erode Purchasing Power?

Inflation is the gradual rise in the prices of a broad range of products and services. If inflation persists at a high level or gets out-of-control, it can eat away your purchasing power—what you can buy with the money you have. The same product that cost $2 six months ago might now cost $4, due to inflation. This rise in prices in turn can erode people's savings and consequently, their standard of living.

What Is the Consumer Price Index?

The CPI measures the prices of certain consumer goods and services over time to discern changes in prices that indicate inflation. The prices for those goods and services are obtained from American consumers by way of the Consumer Expenditure Survey conducted by the Census Bureau for the Bureau of Labor Statistics (which publishes the CPI).

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.


How does CPI relate to purchasing power? ›

The CPI is also used as a deflator of the value of the consumer's dollar to find its purchasing power. The purchasing power of the consumer's dollar measures the change in the value to the consumer of goods and services that a dollar will buy at different dates.

What happens to purchasing power when CPI increases? ›

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.

What is the relationship between CPI and PPI? ›

The CPI includes only components of personal consumption that are directly paid for by the consumer, whereas the PPI for personal consumption includes components of personal consumption that are not paid for by the consumer.

How would you explain the consumer price index? ›

What is Consumer Price Index? An indicator which measures average changes over time in prices of fixed basket of goods and services of constant quality and quantity that a reference population acquire quality and quantity that a reference population acquire, use or pay for consumption.

Does purchasing power increase or decrease with inflation? ›

In an inflationary environment, unevenly rising prices inevitably reduce the purchasing power of some consumers, and this erosion of real income is the single biggest cost of inflation. Inflation can also distort purchasing power over time for recipients and payers of fixed interest rates.

What determines the purchasing power of a consumer? ›

Consumer Buying Power

A consumer's buying power represents his or her ability to make purchases. The economy affects buying power. For example, if prices decline, consumers have greater buying power. If the value of the dollar increases relative to foreign currency, consumers have greater buying power.

What causes purchasing power to increase or decrease? ›

Inflation rises.

Over time, inflation increases; the purchasing power of a US dollar decreases as the average price level of consumer goods increases.

How much does inflation reduce purchasing power? ›

Erodes Purchasing Power

An overall rise in prices over time reduces the purchasing power of consumers, since a fixed amount of money will afford progressively less consumption. Consumers lose purchasing power whether inflation is running at 2% or at 4%; they just lose it twice as fast at the higher rate.

What is purchasing power How is it affected by inflation? ›

Purchasing power means how much your money can buy—its “buying power.” Purchasing power affects stock prices, as well as general economic health. Rising inflation will erode the purchasing power of your investments, aka the amount of money you invest will be worth less when you need to use it.

What happens when CPI is too high? ›

The CPI measures the rate of inflation, which is one of the greatest threats to a healthy economy. Inflation eats away at your standard of living if your income doesn't keep pace with rising prices—your cost of living increases over time. A high inflation rate can hurt the economy.

Does higher PPI cause higher CPI? ›

Charts of the Day: PPI Doesn't Lead CPI | Insights | Fisher Investments.

Is higher CPI better or worse? ›

Is a lower CPI figure good for markets, or a higher figure? When the CPI is rising it means that consumer prices are also rising, and when it falls it means consumer prices are generally falling. In short, a higher CPI indicates higher inflation, while a falling CPI indicates lower inflation, or even deflation.

Why is it important to understand the Consumer Price Index? ›

Why we monitor the CPI. The CPI is a simple and familiar measure of price changes, or inflation. Employers use it to make cost-of-living adjustments in wages and salaries. Governments use it to adjust income taxes and social benefits such as the Canada Pension Plan and Old Age Security.

What is the Consumer Price Index Why is it important? ›

The CPI is often used to adjust consumers' income payments (for example, Social Security), to adjust income eligibility levels for government assistance, and to automatically provide cost-of-living wage adjustments to millions of American workers.

What does it mean when CPI increase? ›

When there is an upward change in the CPI, this means there has been an increase in the average change in prices over time. This eventually leads to adjustments in the cost of living and income (presumably so that income is adjusted to meet a higher cost of living). This process is referred to as indexation.

Is purchasing power of money equal to price index number? ›

Consumer Price Index (CPI) is the index number which is used to calculate purchasing power of money and real wage.

Who hurts the most from inflation? ›

Right now, it's mostly losers. Inflation benefits those with fixed-rate, low-interest mortgages and some stock investors. Individuals and families on a fixed income, holding variable interest rate debt are hurt the most by inflation.

What are four 4 factors that affect purchasing? ›

In general, there are four factors that influence consumer behaviour. These factors impact whether or not your target customer buys your product. They are cultural, social, personal and psychological.

What are the 4 factors that influence consumer purchases? ›

A customer is surrounded by four key factors when considering any purchase: the product, the price, the promotion and the sales channel. Shopping in a physical store isn't the same experience as shopping online, neither shopping in a website or a mobile app.

What is purchasing power of consumer examples? ›

Consumer buying power is how you (the consumer) decide to spend money. It's all about your behavior. If you have $500 to spend on items each month, then that's your consumer buying power—meaning $500 is how much money you'll put back into the economy when you buy stuff.

How do you maintain purchasing power? ›

Shop strategically. Buy more generic brand products and prescriptions. Save on necessary expenses by using coupons and store loyalty programs. Use membership cards (like Walmart+ and others) to pay 5 cents less per gallon for gasoline, or be strategic with which rewards credit card you use for gas purchases.

What happens when purchasing power is low? ›

The result of a decrease in purchasing power is known as inflation. This generally occurs over time with the increase in money supply produced by a nation for various reasons.

What is the biggest factor affecting purchasing power? ›

The price of goods and services is one of the most important factors influencing the consumer's purchasing power. When the price falls, purchasing power increases, and when prices go up, purchasing power goes down; provided that other factors stay the same.

What increases purchasing power? ›

A higher real income means a higher purchasing power of the income amount, since real income refers to the income adjusted for inflation.

What is a consequence of a rise in the CPI? ›

(CPI) A rise in the inflation rate – means prices are rising at a faster rate. Summary of higher inflation. In the short-run, it is more likely the Central bank will increase interest rates to moderate the inflation rate. Savers who have fixed income may become relatively worse off.


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