What Is the GDP Price Deflator?

The GDP price deflator measures the changes in prices for all of the goods and services produced in an economy. Gross domestic product or GDP represents the total output of good and services. However, as GDP rises and falls, the metric doesn't consider the impact of inflation or rising prices on the GDP results. The GDP deflator shows the extent of price changes on GDP by first establishing a base year, and secondly, comparing current prices to prices in the base year.

The GDP deflator shows how much a change in GDP relies on changes in the price level. The GDP price deflator is also known as the GDP deflator or the implicit price deflator.

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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. The metric includes the prices paid by businesses, the government, and consumers. Typically GDP, expressed as nominal GDP, shows the total output of the country in whole dollar terms. Before we explore the GDP deflator, we must first review how prices can impact the GDP results from one year to another.

For example, let's say the U.S. produced $10 million worth of goods and services in year one. In year two, the output or GDP increased to $12 million. On the surface, it would appear that total output grew by 20% year-on-year. However, if prices rose by 10% from year one to year two, the $12 million GDP figure would be inflated when compared to year one. In other words, the economy only grew by 10% from year one to year two, when considering the impact of inflation. The GDP measure that takes inflation into consideration is called the real GDP. In other words, the nominal GDP for year two would be $12 million while real GDP would be $11 million.

The GDP deflator helps to measure the changes in prices when comparing nominal to real GDP over several periods. The deflator is important because, as we saw in our example, comparing GDP from two different years can give a deceptive result if there's a change in prices between the two years. Without some way to account for the change in prices, an economy that's experiencing price inflation would appear to be growing in dollar terms. However, that same economy might be exhibiting little-to-no growth, but with prices rising, the total output figures would appear higher than what was really being produced.

Key Takeaways

  • The GDP price deflator measures the changes in prices for all goods and services produced in an economy.
  • Using the GDP deflator helps economists compare the levels of real economic activity from one year to another.
  • Without the GDP deflator, comparing GDP from two different years would yield a deceptive result if prices changed during the two years.
  • The GDP deflator is a more comprehensive inflation measure than the CPI index because it isn't based on a fixed basket of goods.

How to Calculate the GDP Price Deflator

We use the following formula to calculate the GDP price deflator:

GDP Price Deflator=(Nominal GDP÷Real GDP)×100\text{GDP Price Deflator}\! =\!\text{(Nominal GDP}\div \text{Real GDP)}\!\times\!100GDP Price Deflator=(Nominal GDP÷Real GDP)×100

For example, let's say 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 calculated as ($10 billion / $8 billion) x 100, which equals 125.

The result 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 helps identify how much prices have inflated over a specific time period.

The GDP Price Deflator vs. the Consumer Price Index

There are indexes that measure inflation other than the GDP deflator. 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 one of the most commonly used inflation measures in that it reflects changes to a consumer's cost of living.

However, all calculations based on the CPI are direct, meaning the index is calculated using prices of goods and services already included in the index. The fixed basket used in CPI calculations is static and sometimes misses changes in prices of goods 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. For example, changes in consumption patterns or the introduction of new goods and services are automatically reflected in the deflator while they would not be reflected in CPI.

As a result, the GDP deflator captures any changes in an economy's consumption or investment patterns. However, the trends of the GDP deflator are usually similar to the trends in the CPI.