Purchasing power is the value of money based on how many goods or services one currency unit can buy. It is important because, over time, inflation decreases the quantity you can purchase with the same amount of money.
The value of Rs. 100 ten years ago was more than it is today. That is, if a hundred rupees could buy 4 litres of milk in 2014, it can now buy 3-3.5 litres since the value of money has decreased due to inflation.
In this article, we will understand what purchasing power is, why it is important, how it works, and how to measure it.
What is purchasing power?
Simply put, purchasing power is a measure of the quantity of goods, commodities, and services that money can buy at a certain period. It acts as an indicator of the financial health of an economy, allowing businesses to gauge how much their money can buy.
This method is used across the globe by countries to set budgets since it is a simple calculation. By measuring how much a unit of currency can buy at a given period, governments can adjust their financial plans and policies to account for changes in purchasing power and inflation.
Understanding purchasing power in detail with example
When inflation increases, the purchasing power of a currency falls, leading to a rise in prices. This affects everyone in the economy—from consumers to investors and big businesses, as now, everyone will have to spend more.
This eventually leads to a higher cost of living, higher interest rates, increased prices of essential commodities, and reduced savings, which can also impact the broader global market.
Let’s understand how purchasing power works with the help of an example. The average price of 1 kg of wheat in India in 1994 was approximately Rs. 4.30. However, the average price of 1 kg of wheat in India in 2024 is approximately Rs. 23.46
Over the past 30 years, the price of wheat has increased by Rs. 19.16, which might not seem like a huge number for over 3 decades. However, if you calculate this in percentage terms, it is an increase of approximately 445.58%, which is quite significant. This shows the decline in the purchasing power of the rupee.
Key takeaways
- Purchasing power denotes the number of goods and services that can be bought by a unit of currency at a given point in time.
- With a rise in inflation, the purchasing power of a currency reduces over time.
- The central banks of countries adjust interest rates according to domestic and global conditions to maintain price stability and maintain the purchasing power of the consumer.
- Due to globalisation, it has become more important than ever to protect the purchasing power of citizens as economies today are very closely interlinked.
- Consumer Price Index (CPI) is one of the most commonly used measures across the globe to track changes in purchasing power.
Why is purchasing power important?
Here are some of the reasons why purchasing power is an important aspect of every economy.
1. Standard of living
It directly affects people's ability to afford goods and services. Higher purchasing power means people can buy more with the same amount of money, improving their standard of living.
2. Economic stability
It helps measure the economic stability of a country. When purchasing power decreases due to inflation, it can lead to decreased consumer spending, which can slow down economic growth.
3. Wages and salaries
Purchasing power influences wage negotiations and salary adjustments. Employers and employees need to consider changes in purchasing power to ensure that wages keep pace with inflation, maintaining the real income of workers.
- Investment decisions: Investors consider purchasing power when making decisions. Inflation erodes the value of money over time, so understanding purchasing power helps in making informed investment choices that preserve or increase wealth.
How does purchasing power work?
If the prices of goods in an economy increase, your ability to purchase more units of the same decreases. This means that the purchasing power of the currency you hold—let’s consider the rupee in this case—has decreased.
However, if the value of the purchasing power of a currency falls, it does not always mean that your purchasing power is lowered. If your inflows have increased proportionally to the inflation, you will be able to purchase as much as you did earlier.
Gain/Loss in purchasing power
An increase or decrease in the value of the currency leads to a gain or loss in purchasing power. If prices increase, the purchasing power of a consumer falls, and if the prices of goods decrease, then the purchasing power increases.
This loss or gain of purchasing power happens due to multiple reasons:
Gain in purchasing power: Deflation in the economy, technological breakthroughs that make goods cheaper, etc.
Loss in purchasing power: Natural disasters, rising inflation, government policies, wars, etc.
How is purchasing power calculated?
Purchasing power can be calculated and assessed in different ways, depending on the context. However, a common approach involves comparing the price levels of a basket of goods and services over time or across different regions.
Let’s look at some of the most widely used methods to calculate purchasing power.
1. Purchasing power and CPI
CPI, or Consumer Price Index, is a popular measure of purchasing power and inflation. With CPI, you can calculate the differences in the weighted average of prices across consumer goods, commodities, services, medicine, logistics, food, etc., at any given point in time.
This index measures the overall changes in the prices of consumer goods based on a representative basket of goods and services. CPI is closely tracked by policymakers, economists, governments, financial markets, and consumers to gauge the financial health of the economy.
2. Purchasing price parity
This macroeconomic metric is used to compare the economic output and standard of living between two economies or countries.
In purchasing power parity, the currencies of two countries are compared through the "basket of goods" approach. Simply put, PPP is the exchange rate at which the currency of one country would need to be converted into that of another country to buy an equivalent basket of goods and services.
Example of purchasing power
Let’s take the example of the 2008 financial crisis, which led to a global decrease in purchasing power.
Job losses in the United States led to a sharp decline in consumer purchasing power. As fewer items were being purchased, countries whose exports depended on the USA also saw reduced demand, which in turn affected their economic growth.
The huge exchange rate fluctuations during the crisis added more fuel to the fire, as weaker currencies saw a sharp decline in purchasing power due to imports becoming more expensive. This led to a domino effect around the world, where almost every country felt the effect of the crisis to varying degrees.
Fluctuations in purchasing power
A decrease in purchasing power leads to inflation because of the increase in a nation's money supply over the years.
Hyperinflation was caused by exceptional circumstances like WW1, when Germany had to print a lot of money to pay off its mounting debts, which led to a severe decrease in the value of its currency. This resulted in a huge dip in the purchasing power of its citizens.
What is the purchasing power of India?
India's GDP has shown remarkable growth in recent years, maintaining a rate above 7 percent in 2022-23, surpassing many expectations, especially given the global economic uncertainty due to ongoing conflicts.
In terms of purchasing power parity (PPP), India now represents 6.7 percent of the world's GDP, amounting to $8,051 billion out of a total of $119,547 billion. This is in comparison to China and the United States, which account for 16.4 percent and 16.3 percent, respectively.
How purchasing power affects investments
Purchasing power refers to the value of money in terms of the goods and services it can buy. In the Indian market, purchasing power plays a crucial role in shaping investment decisions. Inflation directly impacts purchasing power, as rising prices reduce the real value of money, affecting savings and returns. When inflation is high, fixed-income investments like Fixed Deposits (FDs) and bonds may offer lower real returns, while equity and real estate investments may provide better hedging options.
Additionally, purchasing power influences consumer spending and corporate profitability, which in turn impacts the stock market. A decline in purchasing power leads to lower demand for goods and services, affecting company revenues and share prices. On the other hand, increasing purchasing power due to rising income levels, lower inflation, or favorable economic conditions can lead to higher investment activity. Investors must assess purchasing power trends when making financial decisions to ensure their investments yield inflation-adjusted growth over time.
Factors that affect purchasing power
Several factors influence purchasing power in India, affecting both individual consumers and the broader investment landscape:
1. Inflation
- The primary factor that reduces purchasing power.
- As prices of goods and services rise, the value of money decreases, making it more expensive to maintain the same standard of living.
2. Interest rates
- Higher interest rates increase borrowing costs, reducing disposable income and spending power.
- Lower interest rates encourage borrowing and spending, boosting economic growth.
3. Income levels
- Rising wages and employment opportunities increase disposable income, improving purchasing power.
- Job losses or wage stagnation negatively impact purchasing capacity.
4. Currency exchange rates
- A weak Indian Rupee (INR) makes imports expensive, reducing purchasing power for imported goods.
- A strong Rupee improves affordability for foreign products and services.
5. Taxation and government policies
- High taxes on income, goods, and services (GST) reduce disposable income.
- Government subsidies and tax reliefs enhance consumer spending and investment capacity.
6. Supply and demand dynamics
- Increased demand for essential goods like food and fuel raises prices, reducing purchasing power.
- A balanced demand-supply mechanism helps maintain stable prices.
7. Economic growth and stability
- A growing economy leads to higher employment, better wages, and increased consumer confidence, strengthening purchasing power.
- Economic downturns and recessions result in lower incomes and reduced spending.
8. Cost of living
- Rising costs of housing, healthcare, and education directly impact household budgets, lowering overall purchasing power.
- Regions with lower costs of living allow better spending flexibility.
Conclusion
Understanding purchasing power is crucial for gauging the economic health and stability of a country. It directly affects consumers, businesses, and policymakers, influencing everything from living standards to investment decisions.
Examples and metrics like CPI and PPP illustrate how purchasing power fluctuates due to inflation, economic policies, and global events. By tracking these changes, individuals and governments can make informed decisions to safeguard and enhance economic well-being.