What Is Purchasing Power? How Purchasing Power Works

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Purchasing power (or buying power) is the amount of goods and services that a single unit of currency can buy. For example, if you purchase a can of soda for one US dollar, but the following year a can of soda costs two US dollars, the purchasing power of a single US dollar changed. Inflation decreases a currency's purchasing power as the price of goods and services goes up. The US Bureau of Labor Statistics tracks the inflation rate and changes in the cost of goods with the consumer price index (CPI).

In cases of hyperinflation, when purchasing power plummets, government regulations may arise to curb the drop in purchasing power and protect economic well-being. In the US, these regulations may include fiscal policies like stimulus packages and discount programs or changes to monetary policies by the Federal Reserve, such as lowering interest rates and increasing the money supply.

Here’s an example to demonstrate purchasing power, whether you buy goods with cash or credit cards:

1. 1. You use one dollar to buy a good. Whether you purchase food or brand-name products, a unit of currency allows you to buy a set amount of that good at a given time. For example, say you use one US dollar to purchase one candy bar.
2. 2. Inflation rises. Over time, inflation increases; the purchasing power of a US dollar decreases as the average price level of consumer goods increases.
3. 3. Your dollar now has less purchasing power. After a period of inflation, your dollar has less purchasing power because the price of goods increased—one US dollar cannot purchase the same number of goods as before. In the candy bar example, while one dollar once allowed you to purchase one candy bar, over time, the purchasing power of the US dollar decreased, and you cannot buy a candy bar with only one dollar—the cost may now be $1.25 or $2. Ideally, income levels will also rise to meet the inflation level and price changes, meaning you can still afford to purchase the candy bar; however, inflation causes serious problems in buying power for those on fixed incomes.

Purchasing power is directly related to inflation since rising inflation decreases the purchasing power of a unit of currency. A healthy inflation rate means that purchasing power slowly decreases, allowing for healthy economic growth. But in extreme cases of hyperinflation, the value of currency plummets, and costs of goods, cost of living, and other expenditures increase while interest rates rise. In the same vein, deflation would increase the purchasing power of money.

Purchasing Power Parity (PPP) is a theory that makes international comparisons of the purchasing powers of currencies from different countries around the world. PPP is a way to determine the exchange rate between currencies in various countries by comparing the purchasing power of each currency.

Purchasing power is the fundamental unit of measurement in Purchasing Power Parity theory (PPP). Economists can determine purchasing power fluctuation between two countries by assessing the price of a standard basket of goods in each country and comparing the amount of money needed to purchase the goods in each country. PPP is useful when comparing two countries' gross domestic product (GDP) numbers because it can help adjust for the difference in the value of a single unit of currency from country to country. The International Monetary Fund (IMF) and the Organization for Economic Cooperation and Development (OECD) use PPP comparisons to make economic predictions and suggest relevant policy changes.