What is purchasing power?

The purchasing power definition refers to the value of a currency expressed in terms of the number of goods and services that one unit of that currency can buy. If you have $10 in a supermarket, how many items will you be able to purchase with those $10? 

You can think of purchasing power as being the value of your money in terms of how much it can buy. Your purchasing power fluctuates depending on a variety of factors, including location and time. 

What is purchasing power parity? 

The economic theory of purchasing power parity (PPP) is based on the premise that if there were no barriers to trade, the price of goods would be equal in every location. Let’s look at a simple purchasing power parity example – how PPP would impact the price of a bottle of Coca-Cola. 

Assuming there was a free-trade agreement between the UK and the US, the cost of a bottle of Coca-Cola should be the same in both countries if the agreement detailed that Coca-Cola products should be free from any fees or tariffs. 

Purchasing power parity would attempt to estimate the amount that would need to be adjusted in the price of that bottle in order for the exchange between the British pound (GBP) and the US dollar (USD) to match each currency’s purchasing power. Therefore, if a bottle of Coca-Cola costs £0.50 in the UK, then when purchasing that same bottle in the US it should cost the equivalent of £0.50 in USD. 

PPP is a useful tool in economics when conducting a comparative analysis between the cost of living, rates of inflation or deflation, and other economic data points in different countries. 

Where have you heard of purchasing power?

As a common feature of economic models based on the principles of free-market consumer capitalism, you have likely heard the term purchasing power before. Whether you were reading a financial publication, watching the news or trading in the financial markets, references are regularly made to the concept of purchasing power. 

The notion of purchasing power is important because it directly impacts various aspects of a nation’s economy, from stock prices to the cost of goods and services.  

What do you need to know about purchasing power?

In a capitalist economic model, purchasing power is forever decreasing as a nation’s currency slowly loses its value. This devaluation occurs as a result of a process known as inflation. States regularly create new money that goes into circulation in the economy: the more money that is created and is circulating in an economy, the less value each unit of money has. 

As a result, money loses its value over time and, by extension, its purchasing power. This is why $10 in a supermarket today does not buy you as many items as $10 would have bought in that same supermarket 50 years ago. Inflation causes the cost of goods and services to rise over time, resulting in the purchasing power of your money slowly decreasing.