GDP Price Deflator

What Is the GDP Price Deflator?

The GDP price deflator, also known as the GDP deflator or the implicit price deflator, measures the changes in prices for all of the goods and services produced in an economy.

Understanding the GDP Price Deflator

Gross domestic product (GDP) represents the total output of goods and services. However, as GDP rises and falls, the metric doesn't factor the impact of inflation or rising prices into its results. The GDP price deflator addresses this by showing the effect of price changes on GDP, first by establishing a base year and, secondly, by comparing current prices to prices in the base year.

Simply put, the GDP price deflator shows how much a change in GDP relies on changes in the price level. It expresses the extent of price level changes, or inflation, within the economy by tracking the prices paid by businesses, the government, and consumers.

Example of the GDP Price Deflator

Typically GDP, expressed as nominal GDP, shows the total output of the country in whole dollar terms. Before we explore the GDP price deflator, we must first review how prices can impact the GDP figures from one year to another.

For instance, let's say the U.S. produced $10 million worth of goods and services in year one. In year two, the output or GDP then increased to $12 million. On the surface, it would appear that total output grew by 20% year-on-year. However, if prices rose by 10% from year one to year two, the $12 million GDP figure would be inflated when compared to year one.

In reality, the economy only grew by 10% from year one to year two, when considering the impact of inflation. The GDP measure that takes inflation into consideration is called the real GDP. So, in the example above, the nominal GDP for year two would be $12 million, while real GDP would be $11 million.

The GDP price deflator helps to measure the changes in prices when comparing nominal to real GDP over several periods. 

GDP Price Deflator Calculation

We use the following formula to calculate the GDP price deflator:

GDP Price Deflator = (Nominal GDP ÷ Real GDP) × 1 0 0 \text{GDP Price Deflator}\! =\!\text{(Nominal GDP}\div \text{Real GDP)}\!\times\!100 GDP Price Deflator=(Nominal GDP÷Real GDP)×100

So, let's say an economy has a nominal GDP of $10 billion and a real GDP of $8 billion. The economy's GDP price deflator would be calculated as ($10 billion / $8 billion) x 100, which equals 125.

The result means that the aggregate level of prices increased by 25 percent from the base year to the current year. This is because an economy's real GDP is calculated by multiplying its current output by its prices from a base year.

Benefits of the GDP Price Deflator

The GDP price deflator helps identify how much prices have inflated over a specific time period. This is important because, as we saw in our previous example, comparing GDP from two different years can give a deceptive result if there's a change in the price level between the two years.

Without some way to account for the change in prices, an economy that's experiencing price inflation would appear to be growing in dollar terms. However, that same economy might be exhibiting little-to-no growth, but with prices rising, the total output figures would appear higher than what was really being produced.

GDP Price Deflator vs. the Consumer Price Index (CPI)

There are other indexes out there that also measure inflation. Many of these alternatives, such as the popular consumer price index (CPI), are based on a fixed basket of goods.

The CPI, which measures the level of retail prices of goods and services at a specific point in time, is one of the most commonly used inflation measures because it reflects changes to a consumer's cost of living. However, all calculations based on the CPI are direct, meaning the index is computed using prices of goods and services already included in the index.

The fixed basket used in CPI calculations is static and sometimes misses changes in prices of goods outside of the basket of goods. Since GDP isn't based on a fixed basket of goods and services, the GDP price deflator has an advantage over the CPI. For instance, changes in consumption patterns or the introduction of new goods and services are automatically reflected in the deflator but not in the CPI.

What this means is that the GDP price deflator captures any changes in an economy's consumption or investment patterns. That said, it’s worth bearing in mind that the trends of the GDP price deflator are usually similar to the trends illustrated in the CPI.