CPI vs.

GDP Measures of Inflation The inflation rate calculated from the CPI and GDP deflator are usually fairly similar in value. In theory, there is a significant difference between the abilities of each index to capture consumer's consumption choices when a change in price occurs. The CPI uses a fixed basked of goods from some base year, meaning that the quantities of goods and services consumed remains the same from year to year in the eyes of the CPI, whereas the price of goods and services changes. This type of index, where the basket of goods is fixed, is called a Laspeyres index. The GDP deflator, on the other hand, uses a flexible basket of goods that depends on the quantities of goods and services produced within a given year, while the prices of the goods are fixed. This type of index, where the basket of goods is flexible, is called a Paasche index. While both of these indices work for the calculation of inflation, neither is perfect. The following example will help to illustrate why. Let's say that a major disease spreads throughout the country and kills all of the cows. By dramatically limiting supply, this happenstance would cause the price of beef products to jump substantially. As a result, people would stop buying beef and purchase more chicken instead. However, given this situation, the GDP deflator would not reflect the increase in the price of beef products, because if very little beef was consumed, the flexible basket of goods used in the computation would simply change to not include beef. The CPI, on the other hand, would show a huge increase in cost of living because the quantities of beef and milk products consumed would not change even though the prices shot way up. When the prices of goods change, consumers have the ability to substitute lower priced goods for more expensive ones. They also have the ability to continue buying the more expensive ones if they like them enough more than the less expensive ones. The GDP deflator takes into account an infinite amount of substitution. That is, because the index is a Paasche index where the basket of goods is flexible, the index reflects consumers substituting less expensive goods for more expensive ones. The CPI, on the other hand, takes into account zero substitution. That is, because the index is a Laspeyres index where the basket of goods is fixed, the index reflects consumers buying the more expensive goods regardless of the changes in prices. Thus, the GDP deflator method underestimates the impact of a price change upon the consumer because it functions as if the consumer always substitutes a less expensive item for the more expensive one. On the other hand, the CPI method overestimates the impact of a price change upon the consumer because it functions as if the consumer never substitutes. While neither the CPI nor the GDP deflator fully captures consumers' actions resulting from a price change, each captures a unique portion of the change.