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GDP Deflator vs. CPI Index Two price indices to measure Inflation GDP Deflator • Purpose: Converts Nominal GDP into Real GDP – Nominal– Real- absolute dollars from that year 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 Percent per Year 15 Oil Spikes raises CPI more than GDP Deflator CPI 10 Conclusion: Oil is a bigger % of the CPI Index than GDP Deflator GDP deflator 5 0 1965 1970 1975 1980 1985 1990 1995 2000 2005 GDP Deflator math is similar to CPI Index GDP Deflator Index Real GDP = = Nominal GDP Real GDP Nominal GDP X Price Index 100 Base Year will always be 100 X 100 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