Purchasing Power

What Is Purchasing Power?

Purchasing power describes how much you can actually get for your money. A dollar, euro, or any other currency is only worth what it can buy, so when prices in general go up, each unit of currency buys less, and its purchasing power falls. When prices fall, the same money buys more. Economists often call this relationship the inverse of the price level, meaning that the two move in opposite directions.

How It Works

Purchasing power is closely tied to inflation, which is the broad, sustained rise in the prices of goods and services across an economy. If inflation runs at a steady pace, a fixed sum of money gradually covers fewer things each year. Someone holding cash that earns no interest will see its purchasing power shrink over time if prices keep rising. Income, savings, and investment returns are all judged in these real terms once they are adjusted for changing prices.

The concept is often measured using a price index, such as a consumer price index, which tracks the cost of a representative basket of goods and services. Comparing money amounts from different years through such an index allows you to express them in comparable terms.

Real Versus Nominal Returns

Purchasing power is central to the difference between nominal and real return. A nominal return is the stated gain on an investment before adjusting for inflation. The real return subtracts the effect of rising prices, showing how much purchasing power the investment actually added. An investment that earns 5 percent in a year when prices rise by 3 percent has increased purchasing power by roughly 2 percent, while an investment that earns 2 percent during a year of 3 percent inflation has lost some purchasing power even though its balance grew.

Why It Matters to Investors

Investors care about purchasing power because the goal of saving and investing is usually to fund future spending, not merely to hold a larger number on a statement. Long-term plans, such as retirement or education funding, are better evaluated in inflation-adjusted terms. Assets such as equities, real estate, and Treasury Inflation-Protected Securities (TIPS) are often discussed in connection with their ability to preserve purchasing power, although no asset guarantees protection in every period.