Why does the GDP deflator give a different rate of inflation

Why does the GDP deflator give a different rate of inflation than the CPI? Please explain.

Solution

The CPI utilizes a fixed basked of commodities from some base year, implying that the quantities of goods and services consumed remains unchanged from year to year in the eyes of the CPI, whereas the price of goods and services changes. This type of index, where the basket of goods remains fixed, is called a Laspeyres index.

The GDP deflator, on the other hand, utilizes a flexible basket of goods that depends on the amounts of goods and services produced in a given year, whereas the prices of the goods are fixed. This type of index, where the basket of goods is flexible, is known as a Paasche index.

For example, if a major disease spreads in the nation and kills all of the cows. By dramatically limiting supply, this result would cause the price of beef products to rise substantially. So, people would stop buying beef and purchase more chicken instead.But, in this situation, the GDP deflator would not reflect the increase in the price of beef products, because if very little beef was consumed, the flexible basket of goods utilized in the calculation would just change to not include beef. The CPI, however, would show a big increase in cost of living as the amounts of beef and milk products consumed would not change even though the prices increased.