During the mid-1980s, we observed a significant reduction in oil prices. In the United States, we would expect that this reduction in oil prices would cause 5) A) no change in the CPI and a reduction in the GDP deflator. B) a larger reduction in the CPI compared to the GDP deflator. C) an equal reduction in the CPI and GDP deflator. D) a larger reduction in the GDP deflator compared to the CPI

A reduction in the oil prices in United States would lead to a a larger reduction in the GDP deflator than the CPI. Hence, the correct answer in this case is option D) or a larger reduction in the GDP deflator compared to the CPI.

Explanation:

In Macroeconomics GDP deflator and Consumer Price Index (CPI) both indicates the fluctuations or variations in the overall price level of all the goods and services in the economy. However, CPI only includes the prices of goods and services that are finally consumed or purchased by the consumers or buyers in the economy and excludes the goods and services involved in any commercial, business to business or government exchange or transaction. On the other hand, GDP deflator estimates the price level of all the goods and services produced by the economy. Therefore, GDP deflator is a relatively comprehensive and broader price indicator in the economy compared to the CPI and is inclusive of all types of commercial transactions between all entities, unlike CPI. Now, in this context, oil is used both for final consumption by consumers or buyers as well as for commercial purposes or intermediate good by firms and companies for production of final goods and services. In many common instances, oil is heavily traded in the international market and is a major export commodity for most of the oil producing countries. Therefore, CPI, in this case, would only register the reduction in price of oil that has been used only for final consumption by the consumers or buyers in the economy. In contrast, GDP deflator will account for the overall reduction in price of oil that is produced by US in general which is used for all commercial, government or administrative and final consumption. Consequently, oil price reduction in US will cause a relatively higher reduction in its GDP deflator than the CPI.