How GDP Deflator is Calculated?

Introduction

In this article, we are going to discuss what is GDP Deflator and how to calculate it.
The GDP Deflator is also known as GDP Price Deflator or Implicit Price Deflator. It measures the impact of inflation on the gross domestic product during a specified period, usually a year.

Meaning

  • The GDP Price Deflator takes into consideration both the nominal GDP and the real GDP of an economy. As we have discussed in our earlier article, the Nominal GDP represents the value of the finished goods and services which an economy has produced, without considering inflation. Whereas the Real GDP represents the value of the finished goods and services which an economy has produced, adjusted for inflation.
  • Thus, GDP Deflator is a factor by which Nominal GDP is adjusted to calculate Real GDP. It adjusts gross domestic product by removing the effect of rising prices ie. Inflation. It shows how much an economy’s GDP is really growing.
  • Therefore, if there was no inflation involved, the nominal GDP would equal the real GDP. The GDP price inflator calculates the impact of inflation on the finished goods and products by converting an economy’s output into current prices, thereby demonstrating the impact of inflation on the GDP change.
  • It is a measure of price inflation/deflation with respect to a specific base year. The GDP deflator of the base year is equal to 100. Since it is relative to the base year, it will tell us how much the prices have adjusted. If there has been inflation, GDP deflator would be more than the base year prices and if there is deflation, then it would be less.
What is GDP Deflator?
What is GDP Deflator?

Formula

  • Mathematically, GDP Price Deflator is calculated as :
  • GDP Deflator = (Nominal GDP / Real GDP) * 100
  • Where
  • Nominal GDP = GDP evaluated using current market price
  • Real GDP = GDP evaluated using base year price (Inflation adjusted GDP)
  • In this formula, figure 100 indicates the base year price so that the relative data can be interpreted easily.

Example

  • By refering the above formula, we would calculate the Implicit Price deflator for the year 2017. Base year is taken as 2012, where Implicit Price deflator is 100.
  • Nominal GDP= Rs 152.51 Trillion
  • Real GDP= Rs 121.90 Trillion
  • GDP deflator = (152.51 / 121.90) * 100 = 125.10
  • So, GDP deflator is 125.10, in comparison to the base year price of 100.
  • This means that the aggregate level of prices increased by 25.1% from the base year (2012) to the year 2017. Please remember GDP deflator is always calculated in Rupees GDP value to avoid exchange rate impact.
  • This is because an economy’s real GDP is calculated by multiplying its current output by its prices from a base year. So, the GDP deflator will help identify how much prices have inflated over a specific time period.

Importance of GDP Deflator

  1. Apart from GDP Deflator, there are other measures of inflation like Consumer Price Index (CPI) and Wholesale Price Index (or WPI). However, GDP deflator is a much broader and comprehensive measure than CPI and WPI.
  2. Since Gross Domestic Product is an aggregate measure of production, being the sum of all final uses of goods and services (less imports), GDP deflator reflects the prices of all domestically produced goods and services in the economy. Whereas, other inflation measures like CPI and WPI are based on a limited basket of goods and services, thereby not representing the entire economy.
  3. The GDP deflator also includes the prices of investment goods, government services and exports, and excludes the price of imports. Whereas the basket of WPI (at present) has no representation of services sector. 
  4. Changes in consumption patterns or the introduction of new goods and services or structural transformation are automatically reflected in the deflator which is not the case with other inflation measures (CPI & WPI).

However WPI and CPI are available on monthly basis whereas deflator comes with a lag (yearly or quarterly, after quarterly GDP data is released). Hence, monthly change in inflation cannot be tracked using GDP deflator, limiting its usefulness.

Practical Example – GDP Deflator of India

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

GDP Deflator of India
Source : Tradingeconomics.com
GDP Deflator of India
Source : Tradingeconomics.com
  • As it 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 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 which 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%.

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