GDP Deflator

What is GDP Deflator?

The GDP deflator is a measure of the change in the annual domestic production due to change in price rates in the economy and hence it is a measure of the change in nominal GDP and real GDP during a particular year calculated by dividing the Nominal GDP with the real GDP and multiplying the resultant with 100.

It’s a measure of price inflation/deflation with respect to the specific base year and is not based on a fixed basket of goods or services but is allowed to be modified on a yearly basis depending on consumption and investment patterns.

The GDP deflator of the base year is 100.

Formula of GDP Deflator

gdp deflator formula

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For eg:
Source: GDP Deflator (wallstreetmojo.com)

Where,

  • Nominal GDP = GDP evaluated using that current market prices
  • Real GDP = Inflation adjusted measure of all goods and services produced by an economy in a year

How to Calculate GDP Deflator?

Here, we have used the following data for the calculation of this formula.

YearNominal GDPReal GDP
20107,5007,500
20118,8508,000
201210,2408,855
201310,6209,912
201411,61111,352
201513,08211,973

In the below template, we have calculated this Deflator for the year 2010 using the above-mentioned formula of GDP Deflator.

GDP deflator example1.1

So, GDP Deflator calculation for the year 2010 will be –

GDP deflator example 1.2

Similarly, we have calculated the GDP Deflator for the year 2011 to 2015.

Therefore, GDP Deflator calculation for all years will be –

GDP deflator example 1.3

It can be noticed that the deflator is decreasing in 2013 and 2014 compared to the base year of 2010. This indicates that the aggregate price levels are smaller in 2013 and 2014 indicating the impact of inflation on GDP, measuring the price of inflation/deflation compared to the base year.

The GDP deflator can also be used to calculate the inflation levels with the below formula:

Inflation = (GDP of Current Year – GDP of Previous Year) / GDP of Previous Year 

Extending the above example, we have calculated the inflation for 2011 and 2012.

Inflation for 2011

example 1.4

Inflation for 2011 = [(110.6 – 100)/100] = 10.6%

Inflation for 2012

example 1.5

Inflation for 2012 = [(115.6 – 110.6)/100] = 5%

The results highlight how the general price of all goods and services in the economy falls from 10.6% in 2011 to 5% in 2012.

Importance

Though measures like CPI (Consumer Price Index) or WPI (Wholesale Price IndexWholesale Price IndexThe Wholesale Price Index tracks the price movement of products in a set territory and wholesaler jurisdiction. Wholesalers provide, manage, and control commodities, usually commonly traded goods, before they are sent to retailers.read more) are existing, the GDP deflator is a broader concept due to:

  • It reflects the prices of all domestically produced goods and services in the economy compared to CPI or WPI since they are based on a limited basket of goods and services thereby not representing the entire economy.
  • It includes prices of investment goods, government services, and exports while excluding prices of imports. WPI, for instance, does not consider the service sector.
  • Important changes in the consumption patterns or introduction of new goods or services are automatically reflected in the deflator.
  • WPI or CPI is available on a monthly basis whereas deflator comes with a quarterly or yearly lag after GDP is released. Thus, monthly changes in inflation cannot be tracked which does impact its dynamic usefulness.

Practical Example – GDP Deflator of India

The below graph shows the GDP Deflator of the Indian Economy:

graph

source: Tradingeconomics.com

As can be seen the GDP deflator is steadily increasing from 2012 and is at 128.80 points for 2018. A deflator above 100 is an indication of price levels being higher as compared to the base year (2012 in this case). It’s not necessary that inflation is occurring but one can experience deflation after a period of inflation if prices are higher compared to the base year.

  • In the above graph, the base year was changed in 2012 to better reflect the economy as it would cover more sectors. Prior to that, the base year was 2004-05 which required to be changed.
  • Since India is a rapidly growing economy with dynamic changes to its policy the mentioned changes were essential. Also, the increasing deflator reflects a steady increase in inflation due to continuous growth opportunities.
  • As per World Bank Reports for 2017, India ranks 107 for the list of GDP Deflator with an inflation rate of 3%. This can be stated as a comfortable position compared to countries that may be facing hyperinflation such as South Sudan and Somalia. On the contrary, it also does not face the threat of deflation such as Aruba and Liechtenstein. Hence, it is important to keep it at manageable levels.
  • The RBI has adopted the CPI as a nominal inflation anchor because, during 2016, the GDP Deflator suggested the country entering a deflation zone while CPI continuing to exhibit a moderately high inflation level. Such situations can push the economy into deflation with the implication being that corporate earnings and debt servicing ability which closely tracks Nominal GDP will keep on deteriorating while inflation-adjusted GDP (Real GDP) may continue to exhibit growth rate in excess of 7%.

GDP Deflator vs CPI (Consumer Price Index)

Despite the presence of GDP Deflator, the CPI seems to be the preferred tool used by economies for ascertaining the impact of inflation in the country. Let us look at some of the critical differences between GDP Deflator vs CPI

GDP DeflatorCPI (Consumer Price Index)
Reflect the price of all goods and services domestically producedReflects the price of goods and services ultimately purchased by the final consumers
It compares the price of existing produced goods and services against the price of the same goods and services in the base year. This makes the group of goods and services used for GDP computation change automatically over time.It compares the price of the fixed basket of goods and services to the price of a basket in the base year.
It contains the prices of domestic goodsImported goods are also included in the same.
For instance, in the Indian economy, the price change of oil products is not reflected much in the GDP deflator since domestic oil production is low in India.As most of oil/petroleum is imported from Western Asia, whenever the price of oil/petroleum product changes, it is reflected in CPI basket as petroleum products compute larger share within CPI.
Another example can be of ISRO satellite which shall be reflected in the deflator.Assuming the price of ISRO increases, it would not be a part of CPI index as the country does not consume satellite.
It assigns changing weights over time as a composition of GDP changes.Assigns fixed weights to prices of different goods. It’s computed using a fixed basket of goods.

This has been a guide to what is GDP Deflator. Here we discuss how to calculate GDP Deflator using its formula along with practical examples and its importance. We also discuss GDP Deflator vs CPI. You may learn more about economics from the following articles –

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