Purchasing Power (Encyclopedia of Business)
Purchasing power refers to the amount of goods and services a fixed amount of money can purchase. The purchasing power of the dollar is related to changes in prices for different goods and services. Published price indices periodically measure the prices of commodities, retail prices, and prices for the economy as a whole. When prices for commodities increase, the purchasing power of the commodity dollar decreases. When retail prices increase, the purchasing power of the retail dollar decreases. And when prices for the economy as a whole, as reported in the consumer price index (CPI), increase, then the purchasing power of the consumer dollar decreases.
Individuals living on fixed incomes are those who are most affected by price increases and corresponding decreases in purchasing power. Payments to such individuals, including government Social Security payments and a variety of pension payments from private industry, are often tied to changes in the consumer price index. When the consumer price index rises and the purchasing power of the dollar decreases, pension and Social Security payments typically add what is known as a cost of living factor. These additional payments are made to individuals living on fixed incomes in an attempt to maintain the level of purchasing power when prices go up.
In order to more accurately reflect the purchasing power of the dollar, economic statistics are usually reported in current dollars and in constant dollars. Constant dollars are measured against a base year in which a current dollar equals a constant dollar. Then for years before and after the base year, a current dollar is multiplied by a figure known as an implicit deflator to obtain the equivalent value in constant dollars. The deflator takes into account price increases and, depending on the behavior of prices, may change from year to year.
Reporting economic statistics in terms of constant dollars enables economists to compare economic performance from one year to another. Increases of such economic measures as the gross national product (GNP) or disposable personal income that are reported in current dollars would not accurately measure increases in productivity or in real income. Rather, much of the increase in GNP and disposable personal income would simply be due to inflationary factors, such as price increases. However, when such statistics are reported in constant dollars, then the effect of price increases is eliminated and a truer picture of actual production or purchasing power is given.
Economists refer to income reported in current dollars as money income, and income reported in constant dollars as real income. Real income provides a measure of purchasing power, since it takes into account the effect of price changes. When people speak of a dollar not being what it used to be, they mean that it no longer has the purchasing power it once had.
SEE ALSO: Consumer Price Index (CPI)
[David P. Bianco]
Derks, Scott, ed. The Value of a Dollar: Prices and Incomes in the United States, 1860-1989. Detroit: Gale Research, 1994.
May, Robert G., et al. Accounting. Cincinnati, OH: South-Western Publishing Co., 1994.
Munn, Glenn G., et al. Encyclopedia of Banking and Finance. 9th edition. Rolling Meadows, IL: Bankers Publishing Co., 1991.