Question

1. Discuss the difference between GDP deflator and CPI. Why GDP deflator value for Kuwait may not be used to reflect the inflation rate in Kuwait?

2. The nominal interest rate (the interest you pay for your financial borrowing) in Sri Lanka is about 13% while in Kuwait it is about 4%. Discuss the possible reasons for the big difference in nominal interest rates in two countries.

3. In the CPI estimation, the basket of goods and services that are consumed by an average family is kept constant. What are the implications of keeping the basket constant? Should we keep the basket constant all the time for ever?

Answer 1

GDP deflator measures change in overall prices of all the domestically produced goods and services in an economy over a certain period of time ( generally a quarter or an year ). It is measured to calculate overall inflation in an economy for a certain duration of time.

Whereas CPI ( Consumer Price Index ) is an index that measures relative change in prices of a basket of goods and services for a certain period of time ( generally a quarter or an year ). CPI measures change in prices of generally consumable items that are most frequently used by most of the consumers in an economy.

We can see that GDP deflator measures change in prices of all kinds of goods, including goods for industries, exports, and industrial goods etc., whereas CPI measures most commonly used items by consumers in an economy. Therefore, measuring inflation using GDP deflator will provide a relative change in prices of all the goods and services and CPI index provides generally consumed goods by most of the people, which shows CPI index is a more accurate measure of inflation.

Nominal interest is the real interest rate after accounting for inflation which means nominal interest rate includes inflation. A higher nominal interest rate in Sri Lanka means a relatively higher inflation rate in Sri Lanka than Kuwait.

The implications of keeping the basket constant is that inflation rate may not be measured accurately as goods used by consumers keep changing with change in times.

No, we shouldn't keep the basket constant all the time.