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Does the term “purchasing power” make you think of spending your money on brands you believe in? Turns out the phrase doesn’t actually relate to your ability to make a difference (or a statement) with your shopping behavior. 

Here’s what you need to know about purchasing power—and how inflation affects it.

How is GDP measured?

In the U.S., the Bureau of Economic Analysis (the research arm of the Department of Commerce) handles the number-crunching to figure out our GDP. The most common method used counts:

  1. Personal consumption expenditures (how much consumers spend on goods and services)

  2. Gross private domestic investment (how much businesses invest in their domestic production—for example, by buying new manufacturing equipment or software or building new production facilities)

  3. Net exports of goods and services 

  4. Government spending.

To put that into formula terms… GDP = Consumer Spending + Business Investments + Exports - Imports + Government Spending

What is purchasing power?

Put simply, purchasing power means how much your money can buy—its “buying power.” You lose purchasing power when prices go up and gain purchasing power when prices go down. But we can’t talk about purchasing power without also delving into “inflation,” which changes the value of a currency over time.

As you know, what a Rand buys today isn’t what a Rand bought 10 years ago. And while we don’t want to “OK Boomer” anyone, it’s easy to feel a little annoyed when someone older gasps over the price of a product or service and says, “Wow, it only used to cost x.” Yes, prices were much lower when baby boomers were in their early career years, but so were wages. If your salary remains the same but prices rise because of inflation, though, your purchasing power will decrease and you won’t be able to afford to buy as much as you once did.

Inflation is tracked through the Consumer Price Index (CPI), which measures the cost of a basket of 175 consumer goods and services—everything from food items to healthcare to housing prices. Stats SA computes an average cost of these items to determine how much it has changed since the previous check in. That identifies how much inflation there has been, and thus shows you the current purchasing power of your Rand.

It’s important to note that the basket of goods is an average for households, but might not reflect your individual consumption. For example, the overall CPI might only rise 2 percent. So if you pay for your own health insurance and didn’t buy a used car, you might feel as though you have less purchasing power since health insurance rose more sharply and makes up a larger percentage of your personal budget.

What does purchasing power affect?

Purchasing power doesn’t just relate to how much you can buy with your money. It also affects stock prices, as well as general economic health. That’s because if inflation causes purchasing power to decrease significantly, and the cost of living goes up, that will lead to more cash-strapped consumers. 

Interest rates also affect your individual purchasing power. A drop in mortgage rates means your Rands can go further since the total amount you’ll owe on your monthly mortgage payments will be lower.

Economists also look at the purchasing power between countries. They often use the purchasing power parity (PPP) theory, comparing a basket of goods in one currency to that of another, after accounting for exchange rates. The PPP is essentially the exchange rate at which one country’s currency would have to convert to the currency of another country in order to buy the same amount of goods and services. Simply put: If a foreign currency’s value goes up against the Rand, that can affect a South African’s purchasing power 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’s why it’s important to focus on investments that will earn a rate of return that is greater than the value of inflation. When deciding where you intend to invest, take into account such factors as your time horizon and risk tolerance.

A longer time horizon theoretically allows for a more aggressive investment portfolio, with more time for the stock market to recover even if it hits one of its inevitable dips. By contrast, a more conservative portfolio that relies on asset classes with lower fixed rates of return—such as you would find with products like CDs and bonds—may actually lose purchasing power over the years due to inflation. 

Also remember that the earlier you start investing, the better. That’s because you’ll have more time to put the power of compound interest to work, which means that you are earning interest on your interest over and over, which can help your account grow sizably over the long run. 

The whole goal of investing is to have more money in the future when you need it, which is why it’s important to understand the effect that inflation can have as you put together your investment strategy. 

This article has been distributed for educational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.

The Economy

What is purchasing power and how does inflation affect it?

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