Purchasing Power: What It Is and Why It Matters
Purchasing power refers to the amount of goods and services that a specific amount of money can buy. Changes in prices over time can increase or reduce the purchasing power of money.
What Is Purchasing Power?
Purchasing power describes the real-world value of money in terms of what it can purchase. If prices remain stable, the purchasing power of a given amount of money may remain relatively unchanged. If prices rise, the same amount may buy fewer goods and services.
The more goods and services a specific amount of money can buy, the greater its purchasing power.
How Inflation Affects Purchasing Power
Inflation can reduce purchasing power because prices may rise over time. This means that money held without sufficient growth may gradually lose some of its ability to buy the same goods and services.
If a product costs 100 today and later costs 120, the original 100 no longer has enough purchasing power to buy the same product. This is a simplified illustration.
Why Purchasing Power Matters
Purchasing power is important because financial goals are usually connected to future expenses. Retirement, education, housing, travel and other goals may cost more in the future than they do today.
When planning, it can therefore be useful to consider not only how much money may be available in the future, but also what that money may realistically be able to purchase.
Purchasing Power and Savings
Savings can provide stability and liquidity, but the purchasing power of cash may change over time. The effect depends on the return earned on savings, inflation, taxes, fees and the time period involved.
A positive nominal return does not automatically mean that purchasing power has increased. If prices rise faster than the growth of money, real purchasing power may decline.
Nominal Value vs Real Value
Nominal value refers to an amount measured in current monetary terms. Real value attempts to account for changes in purchasing power caused by changes in prices.
If money grows from 100 to 108, its nominal value has increased by 8%. However, if the general cost of goods and services also rises during that period, the increase in real purchasing power may be lower.
Purchasing Power and Investing
Investors may consider purchasing power when setting long-term financial goals. Some investments may have the potential to grow over time, but all investments involve different levels of risk and returns are not guaranteed.
The objective is not simply to increase the number shown in an account balance. For many long-term goals, maintaining or increasing the ability of money to purchase future goods and services can also be important.
Factors That Can Affect Purchasing Power
- Inflation and changes in overall prices.
- Growth in wages or income.
- Interest and investment returns.
- Taxes and fees.
- Currency movements.
- Changes in the prices of specific goods and services.
- The time horizon of a financial goal.
How to Think About Purchasing Power When Planning
- Estimate how future costs could differ from current costs.
- Consider the time horizon of each financial goal.
- Understand the difference between nominal and real returns.
- Consider inflation when evaluating long-term projections.
- Review investment risks, fees and potential losses.
- Avoid assuming that any investment will always outperform inflation.
Key Takeaways
- Purchasing power measures what a specific amount of money can buy.
- Inflation can reduce purchasing power over time.
- A rise in nominal value does not always mean a rise in real purchasing power.
- Long-term financial planning may need to account for future changes in prices.
- Savings and investments can be affected differently by inflation.
- Investment returns are not guaranteed and may not always exceed inflation.