In previous posts about inflation related topics, I have talked about how real GDP is just Nominal GDP less the amount of inflation. Well, that is true, but it is not the whole story. In order to get the whole story, we must talk about the GDP deflator, which could be considered another measure of inflation. Where the CPI measures a basket of goods and services in urban households, the GDP deflator measures the changes in prices of all goods and services in the economy. If you would still like to think of it as a “basket” of goods and services, the basket is full of all new, domestically produced, final goods and services in the economy in a given year. Ultimately, the GDP deflator allows for an apples-to-apples comparison of real economic activity from one year to another. It is calculated as follows,
GDP Deflator = (Nominal GDP / Real GDP) * 100
As you can see, it is a simple equation that just takes the ratio of the nominal to the real GDP and turns it into a percentage. By adjusting with real GDP in the denominator, the GDP deflator shows how much the change in GDP relies on the changes in price levels (inflation). Since we are so conditioned to positive year over year inflation, it is called the GDP deflator because it deflates the Nominal GDP in order to be measured in terms of the previous year’s dollar value. This way we measure GDP as a function of the actual purchasing power of the dollar at the same point in time.
Let’s use an example to illustrate this further. Assume a given year’s nominal GDP is $20 trillion and a real GDP of $15 trillion. Well, the nominal GDP is measure in terms of the dollar’s value for this year, but the real GDP (nominal GDP less inflation) is measured in terms of the dollar’s value of the previous year because it is less the inflation over the given year. This means our GDP deflator is ($20 trillion / $15 trillion) * 100, or 133%. This means that our nominal GDP is 133% of our real GDP, and our aggregate level of prices increased by 33% from the previous year.
Benefits of the GDP deflator
To reiterate, the GDP deflator identifies how much prices have inflated over a specific time period, and these are the prices of all goods and services that are domestically produced. It also literally deflates the GDP measure to ensure that the specific time period is measured in the same dollar terms, meaning an equivalent level in terms of dollars. This means that we can accurately compare the GDP in the measure year, with that of the base year (the year in which dollar terms we are adjusting to). On the other hand, if we measured everything without this adjustment, we would have a less accurate measure of how the economy is doing. Just look at any financial graph that can be adjusted for inflation and you will see how much of an effect this has.
Above shows a graph of the GDP deflator of the United States since 1961 found at the World Bank website. The most noticeable part of the graphs is the large set of spikes in the 1970s and early 1980s. This is the notorious stagflation of the time. So, with the GDP deflator measuring inflation, it makes sense why it would spike during that inflationary period, but since it measures the change in price levels of the products involved in GDP, it shows that the actual growth in the nominal GDP was largely due only to the increase in price level. Also notice how there are multiple peaks. This gives some credence, not all but it’s worth stating, that when we enter an inflationary or deflationary period, we were not experiencing that setting the entire time. Unfortunately, this graph doesn’t go back far enough to show the 1930s and 1940s because that period shows this point. It is also not the point for this post, so it will be subject to another.
GDP deflator vs. CPI
So, if the GDP deflator is a measure of inflation, how does that compare to the Consumer Price Index (CPI)? Well, they measure the change in price levels of different goods and services. The CPI measures purely Consumer prices, a basket of set goods and services where each good or service has a weighting depending on how much the government thinks people spend on that good or service. In other words, the CPI is a weighted average of the price increase of a set basket of goods and services. On the other hand, the GDP deflator just uses GDP, so it measures all goods and services that are domestically produced. It measures the changes in all price levels of goods and services in the economy, not just the ones consumers buy. There are other differences that involve going more in depth of the nuance of the CPI which I will link a post where I did just that (here).
How is the GDP deflator used?
Similar to the CPI, the GDP deflator is used by both private and public sector entities to adjust certain payments and prices. Some private firms will use the deflator to adjust payments in contracts. Also, the Federal Reserve system itself will use it to tweak monetary policy if the GDP deflator shows that the economy is not doing what they need. Meaning is the change in GDP due to actual growth or just inflation. Naturally, federal agencies use this measure to make their spending plans as well.
Below is a small guide showing multiple government indexes showing whether or not the products they measure are bought by consumers, bought by businesses and governments, produced in the U.S., and imported or exported from the U.S. As we can see, the GDP deflator (also known as the GDP price deflator) measures goods and services that are bought by consumers, businesses, and governments, as well as goods and services that are exported from the United States.
Conclusion
To reiterate, the GDP deflator (aka GDP price deflator) measures the change in price levels of all domestically produced goods and services within a given time period. Both GDP values (nominal and real) measure the same set of goods and services, meaning within the same time period, it is just they measure them in terms of the dollar at different times. For example, the nominal GDP measures them in terms of the dollar’s purchasing power today, whereas the real GDP measures them in terms of the dollar’s purchasing power in the base year (nominal GDP less the inflation that happened during the time period). This measure is used by both public and private sector entities to adjust payments, prices, and policy. Ultimately, the GDP deflator will show how much of the change in GDP was due to only the changes in price levels in the economy. Opposed to the CPI, that measures changes in consumer prices, the GDP deflator measures those changes in prices across the entire domestic economy, and therefore is more applicable to measuring the actual economic production of the entire country.
To your wealth and future,
James Forsythe
