Compare and contrast the GDP deflator and the CPI base on the following scenario

Question

Compare and contrast the GDP deflator and the CPI base on the following scenarios.

a. Starbucks raises the price of Frappuccinos.

b. Caterpillar raises the price of the industrial tractors it manufactures at its Illinois factory.

c. Armani raises the price of the Italian jeans it sells in the U.S.

d. A Brazilian company that produces soccer balls in the United States and exports all of them. And the price of the soccer balls decreases.

e. A Brazilian company that produces soccer balls in the United States and exports all of them. And the price of the soccer balls decreases

Explanation / Answer

CPI measures the change in price of a fixed basket of goods and services purchased by a typical household, over a period. But deflator is the ratio of nominal GDP to real GDP. Therefore, imported goods are excluded from computation of GDP.

(a) Starbucks Frappuccinos are included in both CPI basket and GDP, therefore CPI and GDP deflator will both increase equally, ceteris paribus.

(b) Industrial tractors are not used by households and are excluded from CPI basket, but they are included in GDP (as gross domestic private investment), so included in GDP deflator. Higher price of these tractors will not change CPI but will increase GDP deflator.

(c) Imported jeans are used by households and are included in CPI basket, but they are excluded from GDP, so excluded from GDP deflator. Higher price of these jeans will increase CPI but will not change GDP deflator.

(d) The exported soccer balls are not used by US households and are excluded from CPI basket, but they are included in GDP (as exports), so included in GDP deflator. Lower price of these balls will not change CPI but will decrease GDP deflator.

(e) is same as (d).

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