Purchasing power

What it means

Purchasing power is the amount of goods and services that a given sum of money or income can buy. When prices rise faster than wages, purchasing power falls: the same pay buys less, even if its nominal amount stays the same or rises slightly.

The relationship between prices and purchasing power is described by inflation. In the euro area it is measured by the Harmonised Index of Consumer Prices, HICP. The real wage is the wage adjusted for inflation and shows whether people are actually better or worse off.

The term is also used to compare countries. Purchasing power parity adjusts incomes and prices so that one can compare what people in different countries can buy with an average wage. Lower wages in Slovakia compared with Western Europe are partly offset by lower prices for some services.

How it works in practice

For businesses, customers' purchasing power is an important input when planning sales and prices. When real incomes fall, people cut back on less essential spending, switch to cheaper brands and postpone larger purchases, which shops, restaurants and service providers feel most.

In pay negotiations and collective bargaining, purchasing power is the employees' main argument. If wages do not rise at least in line with inflation, they fall in real terms. Employers should plan payroll budgets with expected inflation and labour market pressure in mind.

In long-term contracts such as leases, purchasing power is protected by an indexation clause. Rent or service charges are adjusted each year according to the consumer price index, so that the landlord can buy roughly the same amount of goods and services with the same rent.

What to watch out for

Averages hide differences. Food and energy prices move differently from electronics prices, so low-income households feel inflation more strongly than the overall index suggests. When pricing for a particular segment, look at what that segment actually spends money on.

Savings in an account lose purchasing power if the interest rate is below inflation, which is expressed by a negative real interest rate. When a company holds cash for a long time, it should consider how to put it to work while keeping the liquidity it needs for day-to-day operations.