GDP Deflator and Inflation Rate by Omkar Abhyankar

 In the previous article, we talked about a price index called the CPI. In this article, we will be exploring another price index called the GDP Deflator. The GDP deflator also measures the change in prices of a particular market basket. It is important to note that the GDP deflator has its own unique market basket and is not the same as the market basket for CPI. The market basket for the GDP deflator contains all goods and services produced in an economy. Let’s identify the key differences between the market basket for the CPI and the market basket for the GDP deflator. The market basket for CPI only contains certain goods and services most commonly bought by consumers while the market basket for the GDP deflator contains all goods and services produced within an economy. Before we identify how the GDP deflator is calculated, let’s jump back to the concept of GDP. To recap, GDP measures the monetary value of all final goods and services produced within an economy in a specific year. How is this related to the GDP deflator? Essentially, GDP measures the monetary value of the goods being produced within an economy. And, we know that the GDP deflator’s market basket contains all goods being produced within an economy. We can notice that the market basket for the GDP deflator and an economy's GDP are essentially the same thing. Therefore, we can use the measurement of GDP as the market basket for the GDP deflator. Let’s look at the formula for calculating the GDP deflator.

GDP Deflator = Nominal GDPReal GDP X 100

Let’s analyze this formula. We can see that the formula uses GDP to measure the total price of the GDP deflator’s market basket. In Fact we can notice that this formula is very similar to the formula for calculating the CPI. First, let’s recap our knowledge about nominal and real GDP. Nominal GDP is not adjusted for inflation while the real GDP is adjusted for inflation. Looking back at the formula for CPI (CPI = Price of Market Basket in the Current YearPrice of Market Basket in the Base Year X 100), we can see that this index was measured by taking the price of the market basket in the current year and dividing it by the price of the market basket in the base year and the quotient was multiplied by 100. Essentially the same thing is happening when calculating the GDP deflator. The nominal GDP does not account for inflation and therefore gives the value of the market basket (which is the value of GDP)  in terms of the current year's inflated price. Therefore, the nominal GDP is essentially measuring the price of the market basket in the current year. The real GDP gives the value of the market basket in terms of another year’s currency to adjust for the inflation. Therefore, the real GDP is essentially measuring the price of the market basket in the base year. The formula for GDP deflator and CPI are essentially the same, that is they both take the quotient of the current year's market basket price and divide it by the base year's market basket price and multiply it by 100. The only difference between the two is their unique market baskets. Now that we have addressed the similarities between the CPI and the GDP deflator, the index system for the GDP deflator is quite similar to that of the CPI. The index 100 represented no change in prices. Index values greater than 100 represent price inflations while index values less than 100 represent price deflations. We can use the same percent change formula to convert this index value into an inflation rate.

Inflation Rate = New GDP Deflator - Old GDP DeflatorOld GDP Deflator X 100

Similar to the formula for calculating the inflation rate using CPI, the “New GDP Deflator'' corresponds with the GDP deflator value of the year being studied and the “Old GDP Deflator” value corresponds to the year previous of the one being studied. Though it is quite implicit, it is important to address one more remark regarding the formula for calculating the GDP deflator. It is important to note that we can use simple algebra to flip this equation around and solve for real GDP and nominal GDP as well when necessary. Here are the formulas when we solve for real GDP and nominal GDP.

Real GDP = Nominal GDPGDPDeflator X 100

Nominal GDP =Real GDP100 X GDP Deflator

Economists must monitor the inflation rate to ensure that an economy remains healthy. Typically small inflation rates such as 1% or 2% are not considered detrimental to the health of an economy. However, large inflation rates need to be monitored so that proper action can be taken to help recover an economy when needed.