Purchasing Power

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DEFINITION of '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.

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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.

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