Q) Distinguish between GDP Deflator and CPI.

[ 5-8 marks]

→ GDP deflator is the ratio of the nominal GDP and the real GDP, also called the implicit price deflator. The
GDP deflator and the CPI give somewhat different information about what’s happening to the overall level
of prices in the economy. The differences between them are stated below:

I. GDP deflator measures the prices of all goods and services produced in the economy, whereas the CPI
measures the prices of only the goods and services that are bought by a typical consumer. Thus, an
increase in the price of goods that are bought by firms or the government will show up in the GDP deflator
but not in the CPI.

II. The GDP deflator includes only those goods that are produced domestically. Imported goods are not a
part of GDP deflator. Hence, an increase in the price of good ‘X’ made in Japan and sold in India affects the
CPI because the good ‘X’ forms a part of the consumers’ basket, but it will not affect the GDP deflator.

III. The CPI assigns fixed weights to the prices of different goods whereas the GDP deflator assigns changing
weights. In other words, the CPI is computed using a fixed basket of goods whereas the GDP deflator allows
the basket to change over time as the composition of GDP changes.

Example –
Suppose a major frost destroys the nation’s orange crops. The quantity of oranges produced falls to zero
and the price of the few oranges that remain on the grocer’s shelves have sky-rocketed. Since oranges are
no longer a part of GDP, its increase in price does not get reflected in the GDP deflator. But because the CPI
is computed with a fixed basket of goods that include oranges, the increase in the price of oranges causes a
substantial rise in CPI.

CPI is a Laspeyre Index (fixed baskets/weights) while GDP deflator is a Paasche Index (changing weights).
When prices of different goods are changed by different amounts, a Laspeyre Index tends to overstate
inflation (the increase in the cost of living) because it doesn’t take into account that consumers have the
opportunity to substitute less expensive goods for more expensive ones. By contrast, a Paasche Index (GDP
deflator) tends to understate inflation. Although GDP deflator does allow for substitution of alternative
goods, it does not reflect the reduction in consumers’ welfare that may result from such substitution.