Principles of Macroeconomics/Aggregate Activity and Demand/Business cycle/GDP deflator

The GDP deflator is a price index that measures inflation or deflation in an economy by calculating a ratio of nominal GDP to real GDP.

Learning objectives

 * Calculate the GDP deflator and explain how it is used to measure inflation
 * Summarize the importance of inflation in measuring GDP changes over time

Key points

 * The GDP deflator is a measure of price inflation. It is calculated by dividing Nominal GDP by Real GDP and then multiplying by 100.
 * Nominal GDP is the market value of goods and services produced in an economy, unadjusted for inflation. Real GDP is nominal GDP, adjusted for inflation to reflect changes in real output.
 * Trends in the GDP deflator are similar to changes in the Consumer Price Index, which is a different way of measuring inflation.

Terms

 * real GDP: A macroeconomic measure of the value of the economy's output adjusted for price changes (inflation or deflation).
 * GDP deflator: A measure of the level of prices of all new, domestically produced, final goods and services in an economy. It is calculated by computing the ratio of nominal GDP to the real measure of GDP.
 * nominal gdp: A macroeconomic measure of the value of the economy's output that is not adjusted for inflation.

The GDP deflator
The GDP deflator (implicit price deflator for GDP) is a measure of the level of prices of all new, domestically produced, final goods and services in an economy. It is a price index that measures price inflation or deflation, and is calculated using nominal GDP and real GDP.

Nominal GDP versus Real GDP
Nominal GDP, or unadjusted GDP, is the market value of all final goods produced in a geographical region, usually a country. That market value depends on the quantities of goods and services produced and their respective prices. Therefore, if prices change from one period to the next but actual output does not, nominal GDP would also change even though output remained constant.

In contrast, real gross domestic product accounts for price changes that may have occurred due to inflation. In other words, real GDP is nominal GDP adjusted for inflation. If prices change from one period to the next but actual output does not, real GDP would be remain the same. Real GDP reflects changes in real production. If there is no inflation or deflation, nominal GDP will be the same as real GDP.

Calculating the GDP deflator
The GDP deflator is calculated by dividing nominal GDP by real GDP and multiplying by 100.

GDP deflator equation
The GDP deflator measures price inflation in an economy. It is calculated by dividing nominal GDP by real GDP and multiplying by 100.

Consider a numeric example: if nominal GDP is $100,000, and real GDP is $45,000, then the GDP deflator will be 222 (GDP deflator = $100,000/$45,000 * 100 = 222.22).

In the U.S., GDP and GDP deflator are calculated by the U.S. Bureau of Economic Analysis.

Relationship between GDP deflator and CPI
Like the Consumer Price Index (CPI), the GDP deflator is a measure of price inflation/deflation with respect to a specific base year. Similar to the CPI, the GDP deflator of the base year itself is equal to 100. Unlike the CPI, the GDP deflator is not based on a fixed basket of goods and services; the "basket" for the GDP deflator is allowed to change from year to year with people's consumption and investment patterns. However, trends in the GDP deflator will be similar to trends in the CPI.

Source: Boundless. “The GDP Deflator.” Boundless Economics. Boundless, 21 Jul. 2015. Retrieved 26 Oct. 2015 from https://www.boundless.com/economics/textbooks/boundless-economics-textbook/measuring-output-and-income-19/comparing-real-and-nominal-gdp-94/the-gdp-deflator-358-12455/