GDP Deflator vs. CPI Index

Two price indices to measure Inflation

GDP Deflator

• Purpose: Converts Nominal GDP into Real GDP – Nominal- absolute dollars from that year

– Real- inflation adjusted dollars from base year• Real dollars also called “Constant Dollars “

• Only real GDP reflects true quantity of goods/services produced

If Real GDP => you are making more goods/services

GDP Deflator vs. CPI Index

• Both measure inflation but two important differences often cause them to diverge

• GDP deflator reflects prices of all goods/services produced domestically – broader index than CPI but excludes imports

• CPI index reflects prices only a market basket of some goods/services bought by consumers – Narrow, consumer index, but includes imports

Two Measures of Inflation Diverge

1965

Percentper Year

15

CPI

GDP deflator

10

5

01970 1975 1980 1985 1990 20001995 2005

Oil Spikes raises CPI more

than GDPDeflator

Conclusion: Oil is a bigger % of the CPI Index than GDP Deflator

Nominal GDP Real GDP

X 100GDP Deflator Index =

Base Year will always be 100

GDP Deflator math is similar to CPI Index

Real GDP = Nominal GDP X 100 Price Index

Why Inflation is Bad?

• Difficult for Business to plan for future– price goods/services unclear

– Investment becomes difficult

• Lowers value of U.S. currency

• Lowers purchasing power (real value of money)

• Raises long term interest rates– Bond buyers need more nominal interest!

Formula Sheet