Understanding Purchasing Power

by Sujata Srinivasan

Purchasing power is the quantity of goods and services that you can buy with a single dollar at different time periods. The government increases the money supply in the economy via an expansionary monetary policy. When more money enters the market, it ends up chasing a limited number of goods, which results in inflation. The value of the dollar falls, so you are forced to purchase fewer goods for the same amount of money.

Inflation and Purchasing Power

Surely you've heard Dad or Grandpa reminiscing about the good old days, when a gallon of gas cost 20 cents and a four-year college degree was priced at just $15,000, boarding included. What can you buy with a dollar today? Surely a lot less than what you could have even 10 years ago. That's because over time, inflation erodes a currency's purchasing power. Per the inflation calculator at the U.S. Bureau of Labor Statistics (BLS), $1 in 1960 had the purchasing power of $7.35 in 2010. The Consumer Price Index calculates the price of a bundle of consumer goods on a monthly basis, which provides information on the purchasing power of the dollar.

Income Effect on Purchasing Power

The law of demand is a fundamental economic theory. It states that when the price of a good increases, the quantity demanded decreases, and vice versa. This is because a change in product price will affect your real income. Increasing the price of a product will reduce the purchasing power of your money or income. Conversely, a price reduction will increase the purchasing power of your dollar.

Purchasing Power Parity

The economic law of one price states that similar goods will cost the same in geographically different but efficient markets. Purchasing power parity (PPP) is when the exchange rates adjust to similar price levels for the same good over a period of time. A can of Coke should cost the same in dollar value in the United States, China or Timbuktu. A comparison of the exchange rate with the PPPs will reveal the value of a currency. However, the law of one price does not apply when there are differences in transaction costs, such as transportation. "The Economist" magazine created the McDonald's Big Mac index to measure relative currency values because the hamburger is available in about 120 countries.

Relative and Absolute Purchasing Power Parity

The law of one price drives absolute purchasing power parity, per which a good must cost the same anywhere in the world. Relative PPP is subject to inflation. The higher the inflation, the lower the purchasing power of that country’s currency.


The people who are most affected when the purchasing power of the dollar weakens are those on a limited, fixed income and a tight budget, such as retirees. You can avoid purchasing power risk by investing in long-term inflation-adjusted financial instruments such as Treasury bonds.

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