Ch 10 CPI and GDP deflator

Measuring Inflation
{ Warning: May not be suitable for
SL students
How to measure Inflation?
We know that inflation is a
continuing increase in the general
price level. But prices of goods and
services are always changing, so how
do we calculate an accurate measure
of an overall change in prices?
Price indexes to the rescue
What’s a price index?
A measure of average prices in one
period relative to the average prices
in a reference period, (or base year)
There are two main types
of price indexes…..
Consumer Price
Index (CPI)
{ The CPI (used in the U.S.A.) is a
measure of the cost of goods and
services purchased by the typical
household, aka the Retail Price Index
(RPI) in the U.K.
So how do they
{ The CPI and RPI relate the average
prices of thousands of goods and
services in a given year to the average
prices of the same basket in the base
Can we see an example
Is it really that easy?
No, that’s a simplified example.
Statisticians calculate the price of
thousands of goods and then weight
the value of each item in the basket,
but that is more than we have to
And please
If you are going to compare CPI
numbers, they must reference the
same base year and compare the
same basket of goods in order to
compare one year to another
The GDP deflator
This is an alternate way to measure
the average level of prices of all goods
and services included in GDP
GDP deflator
GDP deflator = nominal GDP/real
GDP X 100. So if nominal GDP was
$1160 in 2002, but real GDP was $976,
the GDP deflator would equal 118.8
Comparing GDP
deflator values
{ A GDP deflator value of 118.8 would
tell us that inflation has increased
18.8% since the base year.
Comparing GDP
deflator values
{ If the GDP deflator in 2002 was 118.8
and in 2003 it was 130, we would
calculate as follows: 130-118.8/118.8 X
100 = 9.4%
Shortcomings of the
And sadly, there are many…
Problem # 1
Weighting values of goods are
established in the base year. If the
price of one good rises, consumers
will choose a substitute good.
however, this change in purchasing
habits is not captured by CPI
Problem #2
Stores often run sales which allow
consumers to buy products at prices
lower than that reported by CPI. This
is another example of how CPI may
overstate inflation
Problem #3
Because CPI operates with a fixed
basket of goods and services, new
products introduced are not surveyed
and goods that become less popular
are not immediately replaced in the
Problem #4
The CPI cannot account for quality
changes over a period of time.
Additional problems
CPI doesn’t account for purchasing
variations based on geography, and is
not very reliable when doing
international comparisons
The GDP deflator has
flaws too….
The GDP deflator measures current
output at base year prices, so it
overcomes the problems associated
with a fixed basket of goods.
However, it has other weaknesses…
GDP deflator
{ The GDP deflator measures all goods
and services included in GDP. Why
might this not be relevant to
The GDP deflator
and weighting
{ The GDP deflator doesn’t weight
goods based on their importance to
average households, therefore is not
particularly relevant to consumers.
Final Words….
{ The CPI reflects changes in the cost of
living for consumers, the GDP
deflator reflects changes in average
prices for the economy as a whole, so
CPI is more commonly used.

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