Explain the difference between the CPI and GDP deflator measures of in

Explain the difference between the CPI and GDP deflator measures of inflation. Which one is likely to measure inflation higher? Why?

What will be an ideal response?

ANSWER

The GDP deflator measures the change in prices of all goods and services included in GDP while the CPI measures the change in price of a basket of goods that typical households consume. Because the CPI uses a fixed basket of goods, it ignores substitution to cheaper goods as well as unmeasured changes in quality, new goods, and unmeasured changes in shopping (such as the increased use of discount stores). As a result, the CPI tends to overestimate inflation and measure inflation higher than the GDP deflator.