GDP Deflator and Inflation 5 — Questions and Answers
Question 1: What does it mean when economists say the GDP deflator is a 'Paasche index'?
- It uses the base year's quantity weights
- It uses the current year's quantity weights (Correct answer)
- It averages base-year and current-year weights
- It is weighted by import volumes
Correct answer: It uses the current year's quantity weights
A Paasche index uses the current period's quantities as weights, which is why the GDP deflator's basket changes each year to reflect current output.
Question 2: Which of the following would cause the GDP deflator to rise without causing CPI to rise?
- Higher prices for imported food at US grocery stores
- Higher prices for domestically produced factory machinery (Correct answer)
- Higher rents paid by US households
- Rising tuition at private universities
Correct answer: Higher prices for domestically produced factory machinery
Factory machinery is an investment good captured in GDP (and thus the deflator) but not in the CPI's consumer basket.
Question 3: A central bank uses a 2% inflation target. Which measure would it most commonly use to track this target in the US?
- GDP deflator
- PCE deflator (Correct answer)
- CPI-U
- PPI
Correct answer: PCE deflator
The Federal Reserve's preferred inflation benchmark is the Personal Consumption Expenditures (PCE) deflator, not the GDP deflator or CPI.
Question 4: If an economy produces only two goods — apples and cars — and car prices double while apple prices stay flat, the GDP deflator will:
- Double
- Rise by less than double, weighted by the share of each good in GDP (Correct answer)
- Stay flat because apples offset cars
- Rise by exactly 50%
Correct answer: Rise by less than double, weighted by the share of each good in GDP
The deflator is a weighted average; if cars are only part of GDP, their price doubling raises the deflator by a fraction reflecting cars' share of total output.
Question 5: Nominal GDP in Year 1 is $1,000 and real GDP is $1,000. In Year 2, nominal GDP is $1,100 and real GDP is $1,050. What is the GDP deflator in Year 2?
- 100
- 104.8 (Correct answer)
- 105
- 110
Correct answer: 104.8
GDP Deflator Year 2 = (Nominal / Real) × 100 = ($1,100 / $1,050) × 100 ≈ 104.8.
Question 6: Which of the following best explains why the GDP deflator can differ significantly from the CPI in an oil-importing nation when global oil prices spike?
- The CPI excludes energy; the GDP deflator includes it
- Oil imports raise the CPI because households pay more, but the GDP deflator excludes imports (Correct answer)
- The GDP deflator rises more sharply because it counts all production
- Both indices move identically when import prices change
Correct answer: Oil imports raise the CPI because households pay more, but the GDP deflator excludes imports
Imported oil is not domestic production, so it is excluded from the GDP deflator; however, higher oil import prices raise consumer costs captured in the CPI.
Question 7: An economist observes that real GDP has grown 4% but nominal GDP has grown only 2%. This implies:
- Inflation of 2%
- Deflation of approximately 2% (Correct answer)
- A stable price level
- Real GDP cannot grow faster than nominal GDP
Correct answer: Deflation of approximately 2%
If nominal GDP grew less than real GDP, the GDP deflator must have fallen — meaning the overall price level declined, which is deflation.
GDP Deflator and Inflation 5
What does it mean when economists say the GDP deflator is a 'Paasche index'?