Purchasing Power
Purchasing power refers to the value of a currency measured by a person’s ability to buy a certain amount of goods and/or services for the price of this currency. Otherwise, it’s known as a consumer’s buying power, or pricing power.
Purchasing power is changeable and depends on the inflation rate. As the prices of goods and services go up, the consumer’s buying power decreases, because with a high inflation rate people can buy fewer products for the same amount of money. For example, a person who decided to buy a new computer within the budget of $400-500 in 2015 had better options to choose from than the other person with the same budget now. The value of money has a tendency to depreciate with time. However, there are measures taken by the government to slow down inflation.
In the sphere of investment activities the term “purchasing power” has a different meaning – it’s an accessible credit amount in dollars in a person’s brokerage account, according to the existing marginable securities.
Relationship between Purchasing Power and inflation
One of the measures of indicating and slowing down inflation is an index of average price levels of a so-called basic consumer basket, or commodity bundle. Basically, it’s a list of the most common and essential products and expenses of an ordinary person divided into several categories such as food, medical care, housing, etc.
There are different types of consumer baskets designed for counting down different indexes. Let’s focus on one of them – the Consumer Price Index (CPI), or inflation index. This index is similar in different countries. However, it’s noticeable that in the US it’s the one and only official measure of protecting the economy from inflation. The CPI helps the government to stay updated with price changes and take immediate actions in order to stabilize the economic situation. This index also can indicate a deflation, or decrease in prices and therefore the rise of purchasing power. Sometimes it can be a positive tendency demonstrating the country’s increased productivity, but sometimes – it can be a sign of the fall in the money supply.
We can observe the inverse relationship between the purchasing power and current prices. When the first one goes up, the latter starts to move downward. If, on the contrary, the prices start to rise, purchasing power drops down, which means that for the same amount of money you will be able to afford fewer products or services.
The stability of prices is important not only for ordinary consumers, but for the government and the whole country in general. An excessive inflation rate can cause serious damage to the economy and even lead it to a crisis. Along with inflation grows a cost of living. At the same time the purchasing power and credit ratings fall down significantly. From this perspective the price stability gains meaning even worldwide.
Causes of Purchasing Power fluctuations
Purchasing power grows due to:
- deflation;
- boost in productivity and technologies.
Purchasing power falls due to:
- inflation;
- disasters caused by nature or humans.
We’ve already considered the example of purchasing power loss because of inflation. Let’s give a simplified example of the purchasing power gain in case of deflation. Suppose that the level of month deflation is -0,28%. Then products that you bought a month ago for $100, now cost $99,72 meaning that your purchasing power has grown by 0,28%. This month you'll be able to afford more products for the same $100.
Deflation is quite rare and usually occurs in different industries. Let’s illustrate it as well. For example, half a year ago you bought a new mobile phone for $250. Now the price of the same phone decreases to $200 due to the technological development boost. A lot of new models have been produced since the time of your purchase. Consequently, your phone becomes relatively outdated, therefore its price decreases. At the same time purchasing power has grown, because now your phone model is more affordable than it was previously, and you can buy more products for the same $250.
However, note that high deflation levels can cause economic stagnation, or inertness. Some specialists even consider it worse than inflation, because during that economic immobility the level of unemployment can rise significantly.
Purchasing Power Parity (PPP)
As you can guess, purchasing power can vary in different countries. For that reason the purchasing power parity (PPP) has been created – a macroeconomic metric comparing purchasing power of various countries with the help of the mentioned “basket of products”. The PPP helps to define the changes of purchasing power from one country to another, thereby identifying the changes in cost of living, economic development, and subsequently, in value of a certain currency.
Historical examples of severe Purchasing Power fluctuations
Germany after WWI. Germany experienced hyperinflation after World War I. While inflation is a kind of normal economic phenomenon (especially, when it’s around 2%, which is considered to be an ideal level of the inflation rate), hyperinflation refers to an extremely high level of inflation – above 50%. During the 1920s Germany's currency became valueless. After that the country suffered from the consequences of the severe economic crisis.
Global economic crisis of 2008. This crisis influenced the whole world due to increased globalization and currency correlations. It had started with a so-called housing bubble in the US, and then grew worldwide. A lot of countries have experienced an explosive growth of the inflation rate. Purchasing power plummeted as well as the currency value of different countries. Some of them chose quantitative easing (QE) as a measure of stopping the crisis. It’s a specific type of monetary policy with the main idea of purchasing open market long-term securities by the central bank in order to gain money to the country’s economy and pull down the interest rates.
Russian crisis of 2014. The Russian economy suffered a severe decline in the middle of the 2010s due to the significant fall in prices for oil by more than 40%. This fall had a great impact on the economy because of Russia's heavy reliance on export of natural resources. The situation was escalated by the following annexation of Crimea. The country fell under the sanctions of the US and European countries, which aggravated the economic conditions of the country even harder at that time.
Methods of protection from Purchasing Power loss
High and persistent levels of inflation can destroy a nest egg that people have been accumulating for years. Investing is a good way of saving your money and outdoing inflation. However, there are some traps and pitfalls that you should consider in order to protect the initial value of your savings and make your rate of return at least equal to the rate of inflation.
A lot of debt instruments and deposits are more secure than other ways of investing, but usually they have a low interest rate that at some point can be overcome by inflation. Shares, in turn, can generate a significant income over a short period of time. However, they are way more risky than the previous instruments.
You can pay attention to the Treasury inflation-protected securities (TIPS). These securities adapt their interest rate to the current level of inflation. Also, most of the natural resources can maintain their prices relatively at the same level during unstable economic periods. However, you can consult with a professional on this matter and create a well-balanced portfolio.
