The GDP deflator, on the other hand, uses a flexible basket of goods that depends on the quantities of goods and services produced within a given year, while the prices of the goods are fixed. This type of index, where the basket of goods is flexible, is called a Paasche index. While both of these indices work for the calculation of inflation, neither is perfect. The following example will help to illustrate why.
Let's say that a major disease spreads throughout the country and kills all of the cows. By dramatically limiting supply, this happenstance would cause the price of beef products to jump substantially. As a result, people would stop buying beef and purchase more chicken instead. However, given 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 used in the computation would simply change to not include beef. The CPI, on the other hand, would show a huge increase in cost of living because the quantities of beef and milk products consumed would not change even though the prices shot way up.
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 if the consumer always substitutes a less expensive item for the more expensive one. On the other hand, the CPI method overestimates the impact of a price change upon the consumer because it functions as if the consumer never substitutes. While neither the CPI nor the GDP deflator fully captures consumers' actions resulting from a price change, each captures a unique portion of the change.
There are two general categories of effects due to inflation. The first group of effects are caused by expected inflation. That is, these effects are a result of the inflation that economists and consumers plan on year to year. The second group of effects are caused by unexpected inflation. These effects are a result of inflation above and beyond what was expected by economics and consumers. In general, the effects of unexpected inflation are much more harmful than the effects of expected inflation.
The major effects of expected inflation are simply inconveniences. If inflation is expected, people are less likely to hold cash since, over time, this money looses value due to inflation. Instead, people will put cash into interest earning investments to combat the effects of inflation. This can be a bit of a nuisance, since people need money to take care of business. Thus, if consumers expect inflation, they are likely to hold less cash and travel more often to the bank to withdrawal a smaller amount of money. This phenomenon of changed consumer patterns is called the shoeleather cost of inflation, referring to the fact that more frequent trips to the bank will lessen the time it takes to wear out a pair of shoes. The second major inconvenient effect of expected inflation strikes companies that print the prices of their goods and services. If expected inflation makes the real value of the dollar fall over time, firms need to increase their nominal prices to combat the effects of inflation. Unfortunately, this is not always easy, as changing menus, catalogues, and price sheets takes both time and money. The problems of this sort are called the menu costs of inflation. Thus, the two major effects of expected inflation are merely inconveniences in the form of shoeleather costs and menu costs.
If the rate of inflation from one year to the next differs from what economists and consumers expected, then unexpected inflation is said to have occurred. Unlike expected inflation, unexpected inflation can have serious consequences for consumers ranging well beyond inconvenience. The major effect of unexpected inflation is a redistribution of wealth either from lenders to borrowers, or vice versa. In order to understand how this works, it is important to remember that inflation reduces the real value of a dollar (the dollar will not buy as much as it once did). Thus, if a bank lends money to a consumer to purchase a home, and unexpected inflation is high, the money paid back to the bank by the consumer will have less purchasing power or real value than it did when it was originally borrowed because of the effects of inflation. If a bank lends money and inflation turns out to be lower than expected, then the shoe is on the other foot and the lender gains wealth, since the money paid back at interest is of more value than the borrower expected. In volatile circumstances, when inflation seems to be moving unexpectedly, neither lenders nor borrowers will want to risk the chance of hurting themselves financially, and this hesitancy to enter the market will hurt the entire economy.