Consider an economy that only produces and consumes two goods— food and apparel. Suppose the inflation rate based on the consumer price index is higher during the year than that based on the GDP deflator. Assuming underlying tastes and preferences in the economy are the same, what can you say about food and apparel price movements during the year?

Answers:

Since the two price indices yield different inflation rates with preferences remaining constant, the relative price of the two goods must have changed. In other words, the price of one of the goods must have gone up by a greater percentage than the other.

For example, suppose the price of food went up by 10% while the price of apparel went up by 20%. This would induce consumers to substitute away from apparel to food.

As a fixed weight index, the CPI would not take this substitution into account while the GDP deflator would, as it is calculated on the basis of what is actually purchased.

Therefore, the CPI inflation rate would be higher than the rate calculated from the GDP deflator.

If inflation is higher, then the prices of food and apparel will change at different proportions, which will make consumers choose one over the other. For instance, people will purchase the product that is at a lower price or the one they consider a primary necessity, such as food.

Besides, the GDP deflator is deduced taking into account the products which are acquired, so it also bears in mind the goods that are substituted.

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