How do the CPI and the GDP deflator differ as measures of price level changes?

• A. CPI measures average prices paid by urban consumers for a fixed basket of goods and uses fixed weights; the GDP deflator covers all domestically produced goods and services with a changing basket reflecting production.
• B. CPI uses a fixed basket of goods and services, while the GDP deflator covers all domestically produced goods and services with a changing basket.
• C. CPI uses changing weights; GDP deflator uses fixed weights.
• D. CPI measures the price level of capital goods only.

Answer: (B)

The key idea is that these two price measures differ in what they cover and how their weights are determined. The CPI tracks price changes for a fixed basket of goods and services that urban consumers typically buy, with the basket held constant over time. That means the CPI focuses on out-of-pocket costs for a specific set of items, even if people actually change what they buy.

The GDP deflator, on the other hand, measures price changes for all goods and services produced domestically in a given period, and its weighting reflects what was actually produced in that period. Because the basket is tied to current production, it changes over time as the composition of GDP shifts.

Because one index uses a fixed consumer basket and the other uses a basket that evolves with production, they can diverge, especially when the mix of goods and services or import prices change. (Note: the GDP deflator excludes imports, while the CPI includes the prices of goods and services purchased by consumers, including imports.)