Lesson 19 Problems with Measuring Real GDP and the Price Level The implicit GDP price deflator is derived, the measurement of real GDP and the measurement of the price level are intimately related. If a particular measure of real GDP underestimates growth in real GDP, then the rate of inflation is overestimated. In practice, there are three important problems with measuring real GDP and the price level. The first problem was mentioned above, which is that relative prices change over time. How chainweighting corrects for this problem in the measurement of real GDP and, therefore, corrects for the bias that relative price changes would introduce in the measurement of inflation using the implicit GDP price deflator. Changes in relative prices can also introduce severe bias in how the CPI measures inflation. When there is a relative price change, consumers typically purchase less of the goods that have become more expensive and more of those that have become relatively cheap. In the previous example, apples became cheaper relative to oranges in year 2, and the ratio of apples consumed to oranges consumed increased. In computing the CPI, the implicit assumption is that consumers do not change their buying habits when relative price changes occur, which is clearly false. As a result, goods that become relatively more expensive receive a higher weight than they should in the CPI, and, therefore, the CPIbased measure of the rate of inflation is biased upward. This is a serious policy issue because some federal transfer payments, including Social Security, are indexed to the CPI, and, therefore, an upward bias in CPI inflation would also commit the federal government to higher transfer payments, which in turn would increase the size of the federal government budget deficit. Also, federal income tax brackets are geared to CPI inflation. Upward bias in CPI inflation causes tax revenues to fall, increasing the government deficit.