Factors Influencing Purchasing Power

Purchasing power is a term used in economics that is defined as the amount of goods and services that can be purchased with a given amount of currency. Purchasing power is an important economic consideration when determining the cost of living and standard of living in different countries. A variety of factors can influence purchasing power.

Prices

The costs of goods and services are among the most important determinants of purchasing power. When the price level rises, purchasing power decreases, and when the price level falls, purchasing power increases, if all other factors are held equal. For instance, if a dollar will buy me a hamburger today but hamburgers cost $1.10 a year from now, I will need 10 percent more currency to buy a hamburger, meaning each dollar has less purchasing power. Price changes over time are often calculated using a consumer price index (CPI). A CPI tracks the prices of a "basket" of normal consumer goods such as food, clothing, gasoline and other essentials to show the general changes in consumer prices over time.

Real Income

For individuals in an economy, purchasing power depends on real income. Real income is the amount of income a person makes adjusted for changes in prices (inflation). If real income increases, it means a person is able to buy more goods and services with his or her income than was possible in the past. It is important to think of income in "real" terms (adjusted for inflation), since income that is not adjusted for inflation can increase and yet result in less purchasing power. For instance, if you make $50,000 a year and get a $1,000 raise, your purchasing power would still fall if prices rose more than 2 percent that year.

Tax Rate

Higher tax rates tend to decrease the purchasing power of individuals since taxes lower real income. Taxes leave less money in the pockets of individuals, meaning they are able to buy fewer goods and services. This tends to reduce consumer spending, which is a key factor in spurring economic activity and growth. Therefore, higher taxes tend to slow economic growth.

Exchange Rates

Exchange rates influence the purchasing power that a currency has in a foreign country, where goods must be purchased with a different currency. For instance, if hamburgers cost 2 dollars in the United States and 1 euro in Germany, and 2 dollars will buy 1.5 euros, dollars have more purchasing power in Germany than they do in the U.S. because 2 dollars will buy a hamburger with 0.5 euro to spare. Traveling to places where exchange rates result in higher purchasing power per dollar will result in a less-costly trip.

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