Purchasing Power: what is it and how is it calculated?

In short, purchasing power means how much your money can buy: your "purchasing power." When prices go up, you lose purchasing power and when prices go down, you win. But we cannot talk about purchasing power without also delving into the term "inflation", which is when the value of a currency changes over time.

Acquisitive power is the amount of services or goods that a person can acquire through the purchase with one dollar in different periods of time. The money supply increases by the government through expansionary monetary policy. The limited number of goods is pursued when more money enters the market, resulting in inflation.

The value of the dollar falls so a person would buy fewer goods for the same amount of money.

Example

Surely you have heard someone older in your family remember the good times, when a gallon of gasoline cost, say, 20 cents and a four-year college degree was only $ 15,000, including shipment. What can you buy for a dollar today? Surely much less than you could have even 10 years ago.

The reason for this is because, over time, inflation. That's because over time, inflation wears down the purchasing power of a currency. According to the inflation calculator of the BLS (or better known as the Bureau of Labor Statistics of United States) for the year 1960, 1 dollar in had the purchasing power of what in 2010 would be 7.35 Dollars. The Consumer Price Index calculates the price of a package of consumer goods on a monthly basis, which provides information on the purchasing power of the dollar.

So what a dollar buys today is not what it bought 10 years ago. And while we don't want to sound booming, it's easy to get a little upset when someone older's jaw drops at the price of a product or service and says, "Wow, it used to only cost x."

For this reason, if your salary remains the same but prices go up due to inflation, your purchasing power will decrease and you won't be able to afford to buy as much as you used to.

How to calculate it?

To calculate purchasing power, it is important to know the CPI (consumer's price index). This is a figure that is published monthly according to the country, which measures the change in the price of services and consumer goods purchased by households. The percentage change in the consumer price index is commonly used to determine the rate of inflation.

Then, to know the purchasing power, you must multiply the relationship between the CPI of the base year with the CPI of the target year x 100. Let's imagine that the base year CPI is 150.3 for the year 2000 and 200.23 for the year 2010. The formula would be:

(150.3 / 200.23) x 100 = 75.06%

This means that the purchasing power of the dollar decreased by 24.94% from 2000 to 2010.

Because cost-of-living wage increases are directly related to inflation, you can use the CPI index to calculate the expected salary increase per cost of living.

You should investigate what the current CPI is where you live, for example, let's imagine that the CPI is 2.7%. You will need to multiply this CPI percentage by your annual salary to determine the cost of living salary increase for the next year.

Assuming your yearly salary is $ 50,000, the formula would be:

$ 50,000 x 0.027 = $ 1,350

This figure represents the expected cost-of-living salary increase.

You can also calculate the expected increase for an hourly employee by multiplying the CPI figure by the hourly wage. For example, assuming an hourly wage is $ 10, then the formula would be

$ 10 x 0.027 = $ 0.27

What affects purchasing power?

Purchasing power is not only related to how much you can buy with your money. It also affects stock prices, as well as general economic health.. This is because if inflation causes purchasing power to drop significantly and the cost of living to rise, that will lead to more cash-strapped consumers.

Interest rates also affect your individual purchasing power; for example, a 1% drop in interest rates can save you $ 167 per month on a $ 200,000 mortgage. A drop in mortgage rates means that your money can go further, as the total amount you will owe on your monthly mortgage payments will be less.

Across countries, economists also assess purchasing power. The theory of purchasing power parity (PPP) is frequently used, where a basket of goods in one currency is compared with another. All after various exchange rates are considered.

The exchange rate at which the currency of one country is converted into another is the PPP, which is to buy the same amount of services and goods.

Bottom line: if the value of a foreign currency rises against the dollar, that can affect the purchasing power of an American in that country.

How does purchasing power affect my investments?

Rising inflation will erode the purchasing power of your investments. In other words, the amount of money you invested will be worth less when you need to use it.

That is why it is important to focus on investments that will earn a rate of return higher than the value of inflation. When deciding where you plan to invest, consider factors such as your time horizon and risk tolerance.

A longer time horizon theoretically allows for a more aggressive investment portfolio, with longer for the stock market to recover, even if you hit one of your inevitable falls. In contrast, a more conservative portfolio that relies on asset classes with lower fixed rates of return, such as those that you will find with products like certificates of deposit and bonds, you can actually lose purchasing power over the years due to inflation.