Question

The following graph shows the inflation rate in the US between 1965 and 2015.

Inflation 16% rate 14 (percent) 12 10 8 6 4 typ harth 2 0 1965 1975 1985 1995 2005 2015 -4

a. Between 1970 and 1985, inflation rate fluctuated severely. Firms might be unwilling to buy raw materials to produce at that time. Explain (This is related to the cost of inflation.)

b. Is it possible that CPI increases but GDP deflator decreases? Explain.

Answer 1

A) Between 1970-1985, inflation was highly fluctuating with severe ups and downs. For example, between 1970-1975 inflation rose drastically while during 1975-1980 it fell sharply, only to rise again

This made it a very uncertain environment in the economy to make purchases or investment. Businesses shied away from buying raw materials during this time, as they feared prices might fall even further and they go into a loss.

This uncertain environment made firms to not invest in raw material during this time and wait for the economy and inflation to stabilize.

B) The major difference between CPI and GDP deflator is the fact that CPI includes only those goods which are consumed by a consumer in a typical consumer basket, including even foreign goods.

GDP deflator includes prices of all goods and services produced in an economy in a given year, irrespective of them being consumed by the consumers.

It is possible for CPI to increase while at the same time GDP deflator to fall, when the prices of foreign goods consumed by a consumer increase drastically, while the price level of the domestic goods decreased slightly.

This would increase the value of CPI due to increase in price of foreign goods, while GDP deflator would fall.