Economics 101: What Is the GDP Price Deflator and How Is the GDP Price Deflator Calculated?

GDP is one of the most important statistics in economics. It represents three separate conceptions of the strength of an economy:

1. 1. The value of everything that is produced within the country
2. 2. The value of everything that is purchased within the country plus that country’s net exports to other countries
3. 3. The income of all the individuals and businesses within the country.

These three values are the same because everything that we purchase must be first produced and then sold. Then, through the selling of products and services, we earn our income. Therefore, total production, total purchases, and total income for the whole country are the same. Measuring GDP tells us an enormous amount about how we are doing as a nation. If GDP is rising, it signifies that incomes are rising, and consumers are purchasing more. All of this means a stronger economy.

The GDP price deflator is a mathematical tool that allows economic observers to compare the gross domestic product of different eras while accounting for the changes in inflation between those eras. It does this by comparing the real GDP—the total value of goods and services in a particular era—with the nominal GDP, the value of those goods and services based on the contemporaneous value of a particular currency.

For instance, in 2007, the United States had a gross domestic product of 14.48 trillion dollars. In 2008, the GDP was 14.72 trillion dollars, and in 2009 it was 14.42 trillion dollars. On the surface, that looks fairly bad: the economy barely grew in 2008 and it actually contracted in 2009. This would mean that 2008 was bad and 2009 was worse.

But when one factors in inflation rates, the picture changes slightly. It turns out that 2008 enjoyed an average inflation rate of 3.8 percent, whereas 2009 saw a 0.4 percent reduction in the average inflation rate. This means that a US dollar was more valuable in 2008 than it was in 2009, and a more valuable dollar should correspond to greater periods of growth.

When you consider these factors, it turns out that 2008 was an even worse year economically than 2009 was. Why? Because the robust rate of inflation should have accounted for much more growth than actually occurred in 2008.

The GDP price deflator is used to present a more accurate portrait of an economy where currency values may be in flux. If one does not account for fluctuating prices, a country’s economy could appear to have grown when in reality it remained flat or even contracted.

Why is this? Let’s hypothetically say that in a certain region in 2013, handbags cost $10 and in 2014 they cost $15. And let’s also say that in 2013, the region recorded $120 from the sale of handbags while in 2014 it recorded $135 from the sale of handbags. If you simply compare those two totals, it appears that 2014 was a more prosperous year, economically.

But upon closer examination, we can see that:

• $120 in sales of $10 handbags equals 12 handbags sold.
• $135 in sales of $15 handbags equals 9 handbags sold.

Therefore in 2014, there were fewer handbag sales than there were in 2013. It would, therefore, be inaccurate to say that 2014 was an equivocally better year, even though the total value of sales was higher. As such, the GDP price deflator allows economists to have a more precise picture of consumption patterns, as opposed to overall prices.

The GDP price deflator is calculated using the following factors:

• Real GDP
• Nominal GDP
• A multiplier (100)

These combine to create the formula for the GDP Price Deflator: (Nominal GDP ÷ real GDP) x 100 = GDP Price Deflator

The GDP price deflator sometimes goes by different names, including the GDP deflator and the implicit price deflator. However, it is not the same thing as the consumer price index (CPI).

The consumer price index is a tool that economic observers use to track inflation. It represents the average change in prices over time for all components of an economy. These may include:

• Physical goods (such as food, electronics, vehicles, and clothing)
• Professional services (such as those performed by hairstylists, tour guides, gardeners, and tutors)
• Entertainment (such as live music, sporting event tickets, and cable subscriptions)
• Health care (such as doctor’s appointments, medical procedures, and pharmaceuticals)

But the consumer price index uses what’s known as a fixed “market basket” of goods and services from these categories in order to extrapolate a complete picture of the economy. This makes the CPI marginally susceptible to inaccuracies when tracking the prices of goods. Let’s say that the price of refrigerators was included in the CPI “market basket” but the price of dishwashers was not. If there was a massive spike in the price of dishwashers (but not in the price of refrigerators), the CPI wouldn’t register it.

By contrast, the measure of GDP and the GDP price deflator aims to measure every single item in a country’s economy. It is harder to accurately calculate than the CPI, but in theory, it is more inclusive.

Learn more about economics in Paul Krugman’s MasterClass.