What is Purchasing Power?

Welcome back to Inflation Explained, your guide to understanding inflation. Today, we're talking about an important concept that affects everyday life, purchasing power. So what exactly is purchasing power? Simply put, purchasing power is the value of a currency measured by the amount of goods and services that one unit of currency can buy. In other words, it's a measure of the buying power of your money.

Purchasing power is something we monitor because it affects many aspects of the economy. For example, if you have $1, your purchasing power is how much you can buy with that $1.
Now let's talk about inflation and how it affects purchasing power. Inflation is the rate at which the general level of prices for goods and services is rising, and subsequently how purchasing power declines. When general price level is rising and inflation is positive, then the same amount of money buys you less than it did before.

To understand how we measure these changes, our researchers use something called a price index. A price index is a tool that helps us track the changes in the price level of a basket of goods and services over time. For instance, the consumer price index or CPI is a common price index that measures the average change over time in the prices paid by consumers for a market basket of goods and services.

In the case of our earlier example of a $1, we can determine its purchasing power by multiplying the $1 by the price index in the base year, which is usually a hundred, and then dividing it by the value of the current price index. As the price index rises, the purchasing power of a dollar falls.

The concept of purchasing power does not need to be restricted to an item that is fixed over time, such as a unit of currency. It can also be applied to measures that change over time, such as wages and incomes.

Here's how a price index can be used to determine the purchasing power of these measures. Let's say your income increased by 3%, but the price index went up by 2%, then your real inflation adjusted income or your purchasing power increased by 1%. If instead your income only increased by 1%, then the purchasing power of your income would have fallen by 1%. Both examples illustrate that accounting for inflation is critical for determining changes in purchasing power.

So there you have it. Purchasing power, inflation, and price indexes are all interconnected. Understanding these concepts can help you make better financial decisions and understand the real value of your money.

We have all kinds of inflation related resources provided by our Center for Inflation Research, including an inflation calculator that determines a dollar's worth in a year. So we encourage you to check out our website today.