Purchasing Power

Loading the player...

What is 'Purchasing Power'

Purchasing power is the value of a currency expressed in terms of the amount of goods or services that one unit of money can buy. Purchasing power is important because, all else being equal, inflation decreases the amount 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.

BREAKING DOWN 'Purchasing Power'

To measure purchasing power, you would compare against a price index such as the Consumer Price Index (CPI). A simple way to think about purchasing power is to imagine if you made the same salary as your grandfather. Clearly you could survive on much less a few generations ago, however, because of inflation, you would need a greater salary just to maintain the same quality of living.

Each jurisdiction has its own rules governing margin transactions. In the United States you can purchase up to 50% of securities on margin, so, if you had $10,000 in a margin account, you would be able to purchase up to $20,000 worth of securities. Said another way, you have an extra $10,000 of purchasing power (buying power).

Purchasing Power in Context

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 ensue, including rising costs of good 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 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 cost of living, as well as considered a marker for determining rates of inflation and deflation.

A related concept to purchasing power is purchasing price parity (PPP). PPP is an economic theory that estimates the amount that needs to be adjusted of 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 cost of living, or possible rates of inflation and deflation.

History of Purchasing Power

Historical examples of severe inflation and hyperinflation – or the destruction of a currency’s purchasing power – have shown that there are a diverse amount of causes to such a phenomenon. Often expensive, devastating wars will cause an economic collapse, in particular to the losing country, such as Germany during World War One (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.

Today, the effects of the loss of purchasing power is 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 common currency, 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 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 other complex factors.

The European Central Bank (ECB) has 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 has also established strict regulations in the Eurozone on accurately reporting sovereign debt, inflation and other financial data. As a general rule, countries attempt to keep inflation fixed at a rate of 2% as moderate levels of inflation are acceptable, with high levels of deflation leading to economic stagnation.

RELATED TERMS
  1. Purchasing Power Loss/Gain

    An increase or decrease in how much consumers can buy with a ...
  2. Inflation

    The rate at which the general level of prices for goods and services ...
  3. Relative Purchase Power Parity

    An expansion of the purchase power parity theory, which suggests ...
  4. Real Income

    The income of an individual or group after taking into consideration ...
  5. Buying Power

    The money an investor has available to buy securities. In a margin ...
  6. Purchasing Power Parity - PPP

    An economic theory that estimates the amount of adjustment needed ...
Related Articles
  1. Term

    What Is Purchasing Power?

    Purchasing power expresses money’s value by defining the amount of goods or services it can buy.
  2. Fundamental Analysis

    How Inflation Affects Your Cash Savings

    Prices tend to rise over time and this inflation can cut into the value of your savings. Here are some ways you can manage the situation.
  3. Professionals

    Inflation Risk

    CFA Level 1 - Inflation Risk. Briefly describes the effects of inflation risk on the purchasing power of the money invested in bonds. Suggests a few options for protection.
  4. Forex

    Inflation

    An in-depth look at inflation
  5. Economics

    Is U.S. Inflation on the Horizon?

    Inflation, or the general price level of all goods and services in an economy, has remained subdued in the years following the Great Recession. Given recent developments, is the U.S. on the verge ...
  6. Retirement

    Inflation: What Is Inflation?

    Inflation is defined as a sustained increase in the general level of prices for goods and services. It is measured as an annual percentage increase. As inflation rises, every dollar you own buys ...
  7. Economics

    Purchasing Power Parity (PPP)

    Purchasing Power Parity (PPP) compares different countries' currencies through a market "basket of goods" approach. Two currencies are in PPP when a market basket of goods (taking into account ...
  8. Savings

    Why Is Deflation Bad For The Economy?

    While some inflation is good for economic growth, when prices begin to fall after an economic downturn, deflation may set in causing an even deeper crisis.
  9. Investing

    Corporate Bonds and the Impact of Inflation Risk

    The impact of inflation risk affecting corporate bond returns can be significant. It may even result in a real loss of purchasing power.
  10. Forex Education

    Forex Tutorial: Economic Theories, Models, Feeds & Data

    There is a great deal of academic theory revolving around currencies. While often not applicable directly to day-to-day trading, it is helpful to understand the overarching ideas behind the ...
RELATED FAQS
  1. What are the nations with the highest PPP (purchasing power parity) with respect ...

    Learn which nations have the highest PPP with respect to the U.S. while reviewing the differences of calculating GDP in market ... Read Answer >>
  2. How important a metric is PPP (purchasing power parity?)

    Find out why calculations and comparisons of the purchasing power parity (PPP) in different countries can have a real impact ... Read Answer >>
  3. What impact does inflation and deflation have on a blue-chip stock value?

    Learn how inflation and deflation affect the value of blue-chip stocks, and why investing in blue chips can stabilize your ... Read Answer >>
  4. What is the difference between GDP and GDP accounting for PPP (purchasing power parity)?

    Learn how to distinguish between absolute GDP and GDP after accounting for purchasing power parity, or PPP, when comparing ... Read Answer >>
  5. What is inflation and how should it affect my investing?

    Inflation, an economic concept, is an economy-wide sustained trend of increasing prices from one year to the next. The rate ... Read Answer >>
  6. When looking at my online broker account, I see an account value, cash value and ...

    When looking at some online brokerage accounts, there are a few figures that may be confusing, including account value, cash ... Read Answer >>
Hot Definitions
  1. Law Of Demand

    A microeconomic law that states that, all other factors being equal, as the price of a good or service increases, consumer ...
  2. Cost Of Debt

    The effective rate that a company pays on its current debt. This can be measured in either before- or after-tax returns; ...
  3. Yield Curve

    A line that plots the interest rates, at a set point in time, of bonds having equal credit quality, but differing maturity ...
  4. Stop-Limit Order

    An order placed with a broker that combines the features of stop order with those of a limit order. A stop-limit order will ...
  5. Keynesian Economics

    An economic theory of total spending in the economy and its effects on output and inflation. Keynesian economics was developed ...
  6. Society for Worldwide Interbank Financial Telecommunications ...

    A member-owned cooperative that provides safe and secure financial transactions for its members. Established in 1973, the ...
Trading Center