CPI vs GDP Deflator: Comprehensive Notes

Consumer Price Index (CPI)

Measures the overall cost of the goods and services bought by a typical consumer.

Inflation rate

The percentage change in the price level from one period to another. Formula: \text{Inflation rate}\_t = \frac{\text{CPI}\_t - \text{CPI}\_{\text{t}-1}}{\text{CPI}\_{\text{t}-1}} \times 100

Core CPI

CPI excluding food and energy prices, often viewed as a better reflection of underlying inflation trends due to the volatility of food and energy prices.

Producer Price Index (PPI)

Measures prices received by domestic producers; formerly known as the Wholesale Price Index.

Indexed / indexing / COLA

Indexation occurs when a monetary amount is automatically adjusted for changes in the price level; COLA stands for cost-of-living allowance, often tied to the CPI.

Nominal interest rate

Measures the rise in the number of dollars that savers or investors receive.

Real interest rate

Measures the rise in purchasing power, accounting for inflation. Formula: \text{Real interest rate} \approx \text{Nominal interest rate} - \text{Inflation rate} or r = i - \pi

CPI Formula

The formula to calculate the CPI for a given time period $t$: \text{CPI}\_t = \frac{P\_{\text{basket},t}}{P\_{\text{basket},\text{base}}} \times 100

GDP Deflator

A broad price measure that equals the ratio of nominal GDP to real GDP. Formula: \text{GDP Deflator} = \frac{\text{Nominal GDP}}{\text{Real GDP}}

Substitution bias

A problem in measuring the cost of living where a fixed basket of goods understates consumers' substitution towards relatively cheaper goods when prices change, causing an overstatement of the true rise in the cost of living.

Introduction of new goods

A problem in measuring the cost of living where new goods increase consumer opportunities and make each dollar more valuable, but a fixed CPI basket cannot reflect this increased value, leading to a failure to capture improvements in well-being.

Unmeasured quality changes

A problem in measuring the cost of living where changes in the quality of goods and services (e.g., improvement makes a dollar more valuable, worsening makes it less valuable) are difficult to account for, potentially biasing CPI inflation estimates.

Regional Price Parities (RPPs)

Measures variations in the cost of living across states, computed by the BEA using CPI data, with housing costs being a particularly significant factor in these differences.