Question

Describe a situation, either a government policy situation, an economic problem, or a private sector situation, where using the CPI to convert from nominal to real would be more appropriate than using the GDP deflator.

Short answer

In the scenario where a government policy is aimed at providing subsidies for essential consumer goods and services to maintain their affordability and accessibility, using the CPI is more appropriate than using the GDP deflator. The CPI directly measures changes in the prices of goods and services consumed by households, making it a better representation of cost of living changes and the impact on consumer welfare. In contrast, the GDP deflator measures overall changes in the economy, including sectors not directly related to consumer welfare, and therefore may not accurately represent changes in the affordability of essential consumer goods and services.

Step-by-step solution

Identify a situation

A suitable situation for this exercise would be a government policy aimed at providing subsidies for essential consumer goods and services, aiming to maintain the affordability and accessibility of these items for the general public.

Explain the relevance of CPI in the given situation

In this scenario, the government's policy objective is to ensure that the prices of essential goods and services remain affordable for the average consumer. Therefore, the primary focus is on the consumption side of the economy, and how prices of goods and services are affecting the consumers' purchasing power. The CPI is a widely used measure that captures changes in the prices of a basket of goods and services consumed by households. By using the CPI to convert nominal prices to real prices, we can obtain a sense of how the cost of living for an average consumer is changing over time, taking into account inflation.

Explain why using GDP deflator may not be appropriate in this situation

The GDP deflator is a price index that measures changes in the overall price level of the entire economy, including not only consumer goods and services but also investment goods, government purchases, and net exports. In the given situation, using the GDP deflator to convert from nominal to real values may not provide an accurate representation of the changes in the affordability of essential consumer goods and services because it takes into account price changes in other sectors of the economy that may not be directly relevant to consumer welfare.

Summarize the exercise

In summary, when the focus is on the affordability and accessibility of essential goods and services for consumers, using the CPI for converting nominal to real values is more appropriate than using the GDP deflator. The CPI specifically tracks changes in the prices of goods and services consumed by households, making it a better measure of cost of living changes and the impact of government policies targeting consumer welfare.