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The GDP Deflator
In economics, it's helpful to be able to measure the relationship between nominal GDP (aggregate output measured at current prices) and real GDP (aggregate output measured at constant base year prices). To do this, economists have developed the concept of the GDP deflator. The GDP deflator is simply nominal GDP in a given year divided by real GDP in that given year and then multiplied by 100.
Note to students: Your textbook may or may not include the multiply by 100 part in the definition of GDP deflator, so you want to double check and make sure that you are being consistent with your particular text.02of 04
The GDP Deflator Is a Measure of Aggregate Prices
Real GDP, or real output, income, or expenditure, is usually referred to as the variable Y. Nominal GDP, then, is typically referred to as P x Y, where P is a measure of the average or aggregate price level in an economy. The GDP deflator, therefore, can be written as (P x Y)/Y x 100, or P x 100.
This convention shows why the GDP deflator can be thought of as a measure of the average price of all of the goods and services produced in an economy (relative to the base year prices used to calculate real GDP of course).03of 04
The GDP Deflator Can Be Used to Convert Nominal to Real GDP
As its name suggests, the GDP deflator can be used to "deflate" or take inflation out of GDP. In other words, the GDP deflator can be used to convert nominal GDP to real GDP. To perform this conversion, simply divide nominal GDP by the GDP deflator and then multiply by 100 to get the value of real GDP.04of 04
The GDP Deflator Can Be Used to Measure Inflation
Since the GDP deflator is a measure of aggregate prices, economists can calculate a measure of inflation by examining how the level of the GDP deflator changes over time. Inflation is defined as the percent change in the aggregate (i.e. average) price level over a period of time (usually a year), which corresponds to the percent change in the GDP deflator from one year to the next.
As shown above, inflation between period 1 and period 2 is just the difference between the GDP deflator in period 2 and the GDP deflator in period 1, divided by the GDP deflator in period 1 and then multiplied by 100%.
Note, however, that this measure of inflation is different from the measure of inflation calculated using the consumer price index. This is because the GDP deflator is based on all goods produced in an economy, whereas the consumer price index focuses on those items that typical households purchase, regardless of whether they are produced domestically.