GDP Deflator
What is GDP Deflator?
The GDP deflator is a measure of the level of prices of all new, domestically produced, final goods and services in an economy.
It is calculated as the ratio of nominal GDP to real GDP, multiplied by 100, and shows how much prices have changed since the base year. It is a broad measure of inflation that includes all goods and services in GDP, unlike the CPI which uses a fixed basket.
GDP Deflator: a worked example
Suppose an economy makes only laptops and haircuts. In Year 3 it produces 40 laptops selling at $600 and 300 haircuts selling at $24, so nominal GDP is 40 × $600 + 300 × $24 = $24,000 + $7,200 = $31,200. Base year prices were $500 per laptop and $20 per haircut. Value that same Year 3 output at base year prices to get real GDP: 40 × $500 + 300 × $20 = $20,000 + $6,000 = $26,000. The deflator is ($31,200 / $26,000) × 100 = 120, so prices of what this economy actually produced sit 20 percent above the base year. Notice the quantities are identical on both lines, 40 and 300, and only the prices change between them.
The mistake students make with gdp deflator
Students build the deflator the way they built CPI, freezing quantities at base year levels and letting prices move. The two indexes are constructed the opposite way round. CPI fixes a basket of quantities and asks what that basket costs now. The deflator fixes prices at base year levels and accepts whatever quantities the current year actually produced, which is why it is called an implicit deflator: it falls out of dividing nominal GDP by real GDP rather than being priced from a set list. Current quantities, base year prices.
GDP Deflator questions
What is the difference between the GDP deflator and the CPI?
Coverage and weighting separate them. The GDP deflator includes every final good and service produced inside the country, so industrial machinery, government purchases and exports all influence it. CPI tracks only the goods and services households buy. Weighting differs too: the deflator reweights itself each year using current output, while the CPI basket stays fixed, so the deflator does not carry substitution bias and the CPI does. The two can report different inflation rates for the same year.
Can the GDP deflator be less than 100?
A deflator below 100 means the price level is lower than it was in the base year. Any year before the base year normally reads under 100, and a later year drops below 100 only after enough deflation to push prices back under their starting level. A reading of exactly 100 identifies the base year itself, where nominal and real GDP are equal by construction.
Does the GDP deflator include imported goods?
Imported goods stay out of the GDP deflator, because it prices only output produced inside the country. A jump in the price of imported coffee or foreign built phones raises the CPI, since households buy them, while leaving the deflator alone. Exports work the other way, appearing in the deflator because they were produced at home even though no local household consumes them. That gap alone can pull the two inflation measures apart in a year of large import price swings.
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