Purchasing Power Vs Buying Power – Explain Like I’m Five


TL:DR – Buying power is how much money or credit you have to spend. Purchasing power is how much stuff your money can buy. If prices go up (inflation), your money buys less, so your purchasing power drops. But having more money or credit boosts your buying power.

What is Purchasing Power?

Purchasing power is about how much stuff you can buy with a set amount of money. Over time, the value of money changes, usually because of inflation. This makes prices go up, so your money buys less than it used to.

  • Example: Imagine you had $1 fifty years ago. Back then, $1 would have bought several bags of candy. Today, the same $1 buys a couple pieces of candy because prices have increased over time.

Key Points:

  • Inflation: When prices rise, your money buys less. This is why purchasing power decreases as prices go up.
  • Deflation: This is the opposite of inflation. If prices fall, your money buys more, which increases your purchasing power.

Application: When families go shopping and see that groceries or clothes cost more than they did last year, they are feeling the effect of inflation. The same amount of money buys less, so they might need to budget more carefully or cut back on purchases.

What is Buying Power?

Buying power is how much money or credit you have available to buy things, especially when investing. Unlike purchasing power, buying power is about how much you can buy with your resources (including borrowed money), not just what your money is worth.

  • Example: If you have $500 but your broker lets you borrow another $500, your buying power is $1,000. This allows you to buy more even though you only had $500 to start.

Key Points:

  • Credit and Margin: In investing, buying power is boosted by using credit or borrowing money (called margin). This means you can invest more than the money you actually have, but it also increases your risk.
  • Personal Finance: Buying power can also refer to how much money or credit you have for making large purchases, like a house or a car.

How Are They Different?

Although purchasing power and buying power sound similar, they refer to different things.

  • Purchasing power is about the value of your money over time. It measures how much you can buy with a certain amount of money based on inflation. When prices rise, your purchasing power goes down because you can’t buy as much as you used to.
  • Buying power, on the other hand, is about how much money or credit you have available to spend or invest. It includes your cash, savings, and any money you can borrow. The more buying power you have, the more you can afford to buy or invest in.

Comparison Example:

  • If prices rise because of inflation, your purchasing power goes down. You can’t buy as much with $10 as you could before.
  • But if you have access to more money through savings or credit, your buying power goes up. You can buy bigger items or invest in more stocks, even if prices rise.

How Inflation Affects Both

Inflation plays a big role in both purchasing power and buying power, but in different ways.

Purchasing Power:

  • Inflation reduces the value of your money. If prices rise, your money won’t buy as much.
  • Example: If bread cost $1 last year and now it costs $1.50, you’re getting less bread for your dollar, which means your purchasing power has gone down.

Buying Power:

  • Inflation might mean you need more money to buy the same things, but you can increase your buying power by borrowing more money or using credit.
  • Example: You might take out a loan to buy a house even though prices have gone up. This increases your buying power, but you will need to repay the loan later.

Who Does This Impact?

Consumers:

  • Regular people feel the impact of inflation when the cost of things like groceries or gas goes up. Their purchasing power drops because they need more money to buy the same items. But if they have savings or can borrow money, their buying power is higher, letting them make bigger purchases, like cars.

Investors:

  • Inflation can lower the returns investors get from bonds or savings accounts. But with more buying power—through credit or margin accounts—investors can buy more stocks. This increases potential returns, but also adds risk. If the market drops, they could lose more than just their original money.

Businesses:

  • Companies with more buying power can buy goods in bulk and negotiate better deals. This helps them save money and be more profitable. They may use their buying power to secure discounts or cheaper supplies.

Governments:

  • Central banks like the Federal Reserve use interest rates to control inflation. By raising rates, they can slow down inflation, helping to protect the purchasing power of a country’s money.

Common Misunderstandings

Inflation is Always Bad:

  • Not exactly. Some inflation is normal and can be a sign that the economy is growing. However, too much inflation hurts purchasing power, making it harder for people to afford things.

Buying Power is Only Cash:

  • This is incorrect. In investing, buying power includes both cash and borrowed money (like a margin loan). Just having access to credit or loans increases your buying power.

Ethical Concerns

Inflation’s Impact on Lower-Income People:

  • Inflation is hardest on people with fixed incomes, like retirees, because their money doesn’t go as far. They don’t earn more as prices go up, so their purchasing power drops.

Over-Leveraging in Investing:

  • Some investors borrow too much money to increase their buying power. If the stock market drops, they can lose everything, including the money they borrowed. This is risky and can lead to big losses if things don’t go as planned.

How to Protect Your Purchasing Power

Investing in Gold or Stocks:

  • Gold and stocks often grow in value over time. Investing in them can help protect your purchasing power because their value might keep up with or outpace inflation.

Savings and Budgeting:

  • You can protect your buying power by saving money and budgeting carefully. This helps you handle price increases and still have money left over for big purchases or emergencies.

Conclusion

Both purchasing power and buying power are important concepts to understand. Purchasing power tells you how much your money can buy today compared to the past, while buying power is about how much you can spend or invest right now. By understanding these ideas, you can make smarter choices with your money and plan for the future.

Reference Videos

Reference Links

https://knowitolly.com/what-is-purchasing-power-explain-like-im-five/

https://knowitolly.com/understanding-buying-power-explain-like-im-five/

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