How to calculate GDP deflator?
The simple GDP deflation equation is the following:
GDP delfator = Nominal GDP / Real GDP * 100
To have a better insight into the GDP deflator calculator, we need some understanding what is real and nominal GDP. To do that, it might be a good idea to take a simplified numerical example.
Let’s imagine a fictional economy, called La-la-land, which produces only hamburgers and ice-cream.
The table below shows prices and quantities produced of the two goods in the years 2016, 2017, 2018. To compute the nominal GDP of La-la-land, we need to multiply the amounts of hamburgers and ice-cream by their current prices in each year.
However, if we would like to measure the amount produced that is not affected by changes in prices, we use constant prices for the calculation. This computation gives the real GDP, which is calculated in each year by the price of a base year, in our example, prices in 2016.
To calculate the GDP deflator we use our GDP deflator formula for each year. The resulted value shows how the price level of the produced hamburgers and ice-creams has changed compared to the 2016 base year.
With our results, we can find out the inflation rate associating all produced goods in La-la-land. To do that we need to utilize the inflation rate formula with the GDP deflators in different years.
Inflation rate in year 2 = (GDP deflator in year 2 – GDP deflator in year 1) / GDP deflator in year 1 * 100
Substituting our numbers into the formula, the GDP deflator rose in the year 2017 from 100 to 171; the inflation rate is 100 × (171 – 100)/100, or 71 percent. In 2018, the GDP deflator rose to 240 from 171 the previous year, so the inflation rate is 100 × (240 – 171)/171, or 40 percent.
Importance in economics
Since economies in real life are much more complicated than our oversimplified imaginary La-la-land, its good to remember that GDP deflator gives you a picture about the changes in the price level in all factors of the Gross Domestic Product, namely investment and government expenditures, as well as for consumer spending and net exports.
Unlike other price indices, for example the Consumer Price Index (CPI), the GDP deflator formula is not based on a fixed basket of goods and services. The basket is allowed to alter depending on the final consumption and investment in a given year. Therefore, it also reflects consumption and investment patterns. Specifically, for the GDP deflator, the basket in each year is the set of all goods that were produced domestically, weighted by the market value of the total consumption of each good. Therefore, new expenditure patterns are allowed to show up in the deflator as people respond to changing prices. The theory behind this approach is that the GDP deflator reflects up to date expenditure patterns. For instance, if the price of pork increases relative to the price of beef, people may spend more money on pork as a substitute for beef.
In practice, the difference between the deflator and a price index like the Consumer Price Index (CPI) is often relatively small. On the other hand, with governments in developed countries increasingly utilizing price indexes for everything from fiscal and monetary planning to payments to social program recipients, even small differences between inflation measures can shift budget revenues and expenses by millions or billions of dollars.