Definition: Purchasing power is the ability of a single economic factor or a group of economic factors to influence the market prices. More specifically, the buying power of a currency represents the number of goods and services that one unit of currency can buy.
What Does Purchasing Power Mean?
What is the definition of purchasing power? This concept is important in economics, as it has an impact on consumer spending, investment decision-making, and a country’s economic growth. This power takes into account the inflation rate that is calculated by The Bureau of Labor Statistics because inflation decreases the number of goods and services that one unit of currency can buy, ceteris paribus.
When the purchasing power of a currency decreases, the cost of goods and services increases, thus increasing the cost of living and lowering consumer spending and borrowing. Therefore, a moderate decrease in purchasing power suggests that the economy is growing, whereas an increase in buying power indicates stagnation. Furthermore, this power has a significant impact on investment returns.
Let’s look at an example.
Example
Mark invests $5,000 in a 3-year corporate bond that yields 6.25% and expects to collect $5,312.50 at the end of the year 1, $5,644.53 at the end of the year 2, and $5,997.31 at the end of the year 3.
Currently, Mark’s PP is at 4.35% because the interest rates are high, and the inflation rate is 3.5%. The actual return on investment is $5,000 x (6.25% – 4.35%) = $5,000 x 1.90%. Therefore, Mark actually collects $5,095 at the end of the year 1, $5191.81 at the end of the year 2, and $5,290.45 at the end of the year 3.
If Mark’s PP increases to 5%, Mark will realize a lower return on this particular investment, i.e. 1.25%, and he will have to invest in higher risk securities to realize a higher return on investment. Therefore, a change in power affects investment decision-making and asset allocation.
Summary Definition
Define Purchasing Power: Purchasing power means the the value of a currency relative to the amount of goods or services it can buy..
