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Unformatted text preview: When the prices of goods change, consumers have the ability to substitute lower priced goods for more expensive ones. They also have the ability to continue buying the more expensive ones if they like them enough more than the less expensive ones. The GDP deflator takes into account an infinite amount of substitution. That is, because the index is a Paasche index where the basket of goods is flexible, the index reflects consumers substituting less expensive goods for more expensive ones. The CPI, on the other hand, takes into account zero substitution. That is, because the index is a Laspeyres index where the basket of goods is fixed, the index reflects consumers buying the more expensive goods regardless of the changes in prices. Thus, the GDP deflator method underestimates the impact of a price change upon the consumer because it functions as...
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This note was uploaded on 12/13/2011 for the course ECO 1310 taught by Professor Staff during the Fall '10 term at Texas State.
- Fall '10