THE GDP DEFLATOR

The GDP deflator, also described the implicit price deflator for GDP, is defined as the ratio of nominal GDP to real GDP.

GDP Deflator formula

The GDP deflator reveals the status of overall level of prices in the economy.

To better understand this, consider an economy again with only one item, CAR.

If P is the price of the car and Q is the number of units sold, then nominal GDP is the total number of dollars spent on car in that year, P × Q.

The GDP deflator reveals the status of overall level of prices in the economy.

To better understand this, consider an economy again with only one item, CAR.

If P is the price of the car and Q is the number of units sold, then nominal GDP is the total number of dollars spent on car in that year, P × Q.

Then nominal GDP is the total number of dollars spent on the car in that year is P × Q.

Real GDP is the number of cars of bread produced in that year times the price of cars in same base year, Pbase × Q. The GDP deflator is the price of car in that year relative to the price of car in the base year, P/
Pbase.

The definition of the GDP deflator allows us to separate nominal GDP into two parts: one part measures quantities (real GDP) and the other measures prices (the GDP deflator). That is,

Nominal GDP = Real GDP × GDP Deflator.

Nominal GDP calculates the current dollar value of the output of the economy. Real GDP measures the output valued at constant prices. The GDP deflator measures the price of output relative to its price in the base year.

We can also write this equation as…

THE GDP DEFLATOR

This way, you can see how the deflator earns its name: it is used to deflate (that is, take inflation out of) nominal GDP to yield real GDP

GDP Deflator Examples

To understand why this is correct, consider a couple of simple examples.

First, assume that the quantities produced in the market rise over time but prices remain constant.

In this example, both nominal and real GDP increase together, so the GDP deflator is consistent.

Now imagine, instead, that prices increase over time, but the quantities produced stay the same.

Let’s now return to our numerical example in Table below

GDP Deflator Example

The GDP deflator is calculated at the bottom of the table above. For GDP deflator year 2001, nominal GDP is two hundred dollars, and real GDP is same as well, so the GDP deflator is 100.

For the year 2002, nominal GDP is Six hundred dollars, and real GDP is $350, so the GDP deflator is calculated 171.

GDP deflator increased in the year 2002 from 100 to 171 which is 7%.

The GDP deflator is one measure that economists use to monitor the average level of prices in the economy.