Why It Matters
Changes in purchasing power directly or indirectly affect nearly every financial decision, from consumer choices to lending rates, and from asset allocation to stock prices. Purchasing power also offers important clues about the state of an economy. Most economists agree, for example, that moderate decreases in purchasing power are a sign of a growing economy and that increases in purchasing power are a sign of stagnation.
Purchasing power can also distort a company’s financial performance. For example, a company that reports high revenue growth during a period of rising inflation could be misleading shareholders if those revenues were the result of inflationary pressure rather than managerial skill. For this reason, many analysts use inflation information to “deflate” or adjust certain financial measures so they can compare them accurately over time. Inflation can also influence a company’s choices in accounting methods. For example, in a rising cost environment, a company may be tempted to use the FIFO inventory method in order to increase paper profits; in a falling cost environment, LIFO may be better.
Purchasing power also affects securities values by way of the discount rate. When inflation is high or rising, the future dividends or interest payments from an investment are worth less. In broad terms, the higher inflation goes, the higher the discount rate goes, and the lower the value of the security goes. The reverse is also true.
Because the Federal Reserve’s job is to maintain long-term economic prosperity through the execution of monetary policy, it takes a keen interest in purchasing power when deciding whether to raise or lower the federal funds rate. This is one reason some analysts consider inflation a measure of the effectiveness of certain government policies.
Contracts and other obligations involving payments over time often consider purchasing power. For example, many labor contracts tie wage adjustments to changes in the CPI, as do some alimony, child support, rent, royalty, and other obligations affected by changes in purchasing power. People living off fixed incomes are particularly affected by changes in purchasing power, and this is why the government usually adjusts social security checks and food stamps as well as the wages of federal employees and members of the military on a regular basis.
Source: Investing Answers
