Question

Explain the difference between the CPI and GDP price index (Implicit Price Deflator). Which one is a better measure of inflation, and why? Use a graph to support your answer.

Answer 1

The first difference is that the GDP deflator measures the prices of all goods and services produced, whereas the CPI or RPI measures the prices of only the goods and services bought by consumers. Thus, an increase in the price of goods bought by firms or the government will show up in the GDP deflator but not in the CPI or RPI.

The second difference is that the GDP deflator includes only those goods produced domestically. Imported goods are not part of GDP and do not show up in the GDP deflator. For example, an increase in the price of Toyota made in Japan and sold in the U.K. affects the CPI or RPI, because the Toyota is bought by consumers in the U.K., but it does not affect the GDP deflator.

The third difference concerns how the two measures aggregate the many prices in the economy. The CPI or RPI assigns fixed weights to the prices of different goods, whereas the GDP deflator assigns changing weights. In other words, the CPI or RPI is computed using a fixed basket of goods, whereas the GDP deflator allows the basket of goods to change over time as the composition of GDP changes.

B. The Consumer Price Index (CPI) is a measure that examines the weighted average of prices of a basket of consumer goods and services, such as transportation, food, and medical care. It is calculated by taking price changes for each item in the predetermined basket of goods and averaging them. Changes in the CPI are used to assess price changes associated with the cost of living. The CPI is one of the most widely used statistics for identifying periods of inflation or deflation.
Understanding Consumer Price Index (CPI)
The CPI measures the average change in prices over time that consumers pay for a basket of goods and services, commonly known as inflation. Essentially it attempts to quantify the aggregate price level in an economy and thus measure the purchasing power of a country's unit of currency. The weighted average of the prices of goods and services that approximates an individual's consumption patterns is used to calculate CPI.[graph is not available]