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GDP Deflator vs. CPI Index

GDP Deflator vs. CPI Index. Two ways to measure Inflation. 2-Types of Inflation. Demand-Pull Inflation: “Too many dollars chasing too few goods” Spending increases faster than production Demand Side Inflation Cost-Push Inflation

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GDP Deflator vs. CPI Index

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  1. GDP Deflator vs. CPI Index Two ways to measure Inflation

  2. 2-Types of Inflation • Demand-Pull Inflation: • “Too many dollars chasing too few goods” • Spending increases faster than production • Demand Side Inflation • Cost-Push Inflation • Increase in cost of important factors of production (input prices) • examples: large price ↑ of oil, labor, steel, etc….) • Supply Side Inflation

  3. 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 terminterest rates • Bond buyers need more nominal interest!

  4. 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

  5. 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

  6. Oil Spikes raises CPI more than GDP Deflator CPI GDP deflator Two Measures of Inflation Diverge Percent per Year 15 10 Conclusion: Oil is a bigger % of the CPI Index than GDP Deflator 5 0 2005 1965 1970 1975 1980 1985 1990 1995 2000

  7. Problems with CPI • Substitution Bias • New goods • Unmeasured quality changes • Housing Measurement Basket must “evolve” with the market

  8. Nominal GDP Real GDP X100 GDP Deflator math is similar to CPI Index GDP Deflator= Real GDP= Nominal GDP X 100 Price Index Base Year will always be 100

  9. Convert Babe Ruth’s wages in 1931 to 2005 dollars: Ending Index(2005) Base Year Index(1931) XOld Dollar Value (1931) = 2005 dollars 195 15.2 Adjusting numbers for inflation 1931 Salary = $80,000CPI = 15.2 1931 CPI = 1952005 X $80,000 = 1,026,316 (2005 dollars)

  10. Formula Sheet

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