What is the GDP Price Deflator?

The GDP price deflator is a ratio of price levels in two different years that accounts for inflation in the prices of goods and services so that comparisons of real GDP can be made from one year to another by converting output measured at current prices into constant-dollar GDP. This deflator shows how much a change in GDP relies upon changes in the price level. The GDP price deflator is also known as the GDP deflator or the implicit price deflator.

Key Takeaways

  • The GDP price deflator expresses the relative price levels of the goods and services included in GDP for different years.
  • Using the GDP deflator to account for the effects of inflation is key to being able to compare levels of real economic activity from one year to another.
  • The GDP deflator is related to other measures of price level change such as the Consumer Price Index, but has the advantage of also compensating for changes in the composition of consumption and in relative prices between goods.
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GDP Price Deflator

Understanding GDP Price Deflator

The GDP price deflator expresses the extent of price level changes, or inflation, within the economy. This includes the prices paid by businesses, the government, and consumers. Because nominal GDP for each year is counted using dollar denominated sales and spending numbers in that year, and the value of the dollar can fluctuate from year to year, the use of the GDP deflator is needed in order to compare real GDP, or the number of actual units of goods and services counted in GDP, from year to year.

Why is the GDP Deflator Important?

It is important because comparing GDP from two different years in the prices current for those two years can give a deceptive result if there is a change in the price level between the two years. Without some way to account for the change in prices, an economy that is experiencing price inflation will appear to be growing in dollar terms, but may be experiencing little or no growth, or even negative change in real output and income.

How to Calculate the GDP Price Deflator

In order to find the GDP price deflator, you'll need to use the following formula:

GDP Price Deflator = (Nominal GDP ÷ real GDP) x 100

For example, if an economy has a nominal GDP of $10 billion and has a real GDP of $8 billion, the economy's GDP price deflator would be derived as: ($10 billion / $8 billion) x 100, which equals 125.

This means that the aggregate level of prices increased by 25 percent from the base year to the current year. This is because an economy's real GDP is calculated by multiplying its current output by its prices from a base year. So, the GDP deflator will help identify how much prices have inflated over a specific time period.

The GDP Price Deflator vs. the Consumer Price Index

There are indexes other than GDP that help measure an economy's inflation. Many of these alternatives are based on a fixed basket of goods. The consumer price index (CPI), for example, measures the level of retail prices of goods and services at a specific point in time. The CPI is considered by some to be one of the most relevant inflation measures in that it reflects any changes to a consumer's cost of living.

However, all calculations based on the CPI are direct, meaning that the index is only calculated on prices already included in the index. The fixed basket used in CPI calculations is static and sometimes misses changes in prices outside of the basket of goods. Since GDP isn't based on a fixed basket of goods and services, the GDP deflator has an advantage over the CPI: changes in consumption patterns or the introduction of new goods and services are automatically reflected in the deflator.

Theoretically, this allows the GDP deflator to capture any changes to an economy's consumption or investment patterns. However, the trends of the GDP deflator are very closely similar to trends in the CPI.