Which statement about the CPI and the GDP deflator is correct?

• A. The CPI measures prices of all final goods and services produced domestically; the GDP deflator measures a fixed basket of consumer goods.
• B. The CPI measures prices of a fixed basket of consumer goods and services; the GDP deflator measures prices of all final goods and services produced domestically and can change with output composition.
• C. The CPI includes prices of capital goods; the GDP deflator includes consumer goods.
• D. The CPI and the GDP deflator measure the same prices in the same way.

Answer: (B)

The main idea is how each price index measures price changes. The consumer price index tracks the prices of a fixed basket of goods and services bought by households, so its values move only with changes in those item prices (and it includes imports). The GDP deflator, by contrast, measures the prices of all final goods and services produced domestically, and the set of items it covers can change as what the economy produces changes. That means the GDP deflator can shift not just with price changes but also with shifts in the composition of production.

This is why the statement that matches reality is the one where the CPI uses a fixed basket of consumer goods and services, while the GDP deflator covers all final domestically produced goods and services and can change with output composition. The other descriptions mix up what each index measures or imply they track the same prices in the same way, which isn’t correct.