If the consumer price index rises from 101 to 104, which of the following statements is true?

What Is the GDP Price Deflator?

The GDP (gross domestic product) price deflator, also known as the GDP deflator or the implicit price deflator, measures the changes in prices for all the goods and services produced in an economy.

Key Takeaways

• The GDP price deflator measures the changes in prices for all the goods and services produced in an economy.
• Using the GDP price deflator helps economists compare the levels of real economic activity from one year to another.
• The GDP price deflator is a more comprehensive inflation measure than the Consumer Price Index (CPI) index because it isn't based on a fixed basket of goods.

GDP Price Deflator

Understanding the GDP Price Deflator

Gross domestic product (GDP) represents the total output of goods and services. However, as GDP rises and falls, the metric doesn't factor in the impact of inflation or rising prices into its results. The GDP price deflator addresses this by showing the effect of price changes on GDP, first by establishing a base year, and, second, by comparing current prices to prices in the base year.

Simply put, the GDP price deflator shows how much a change in GDP relies on changes in the price level. It expresses the extent of price level changes, or inflation, within the economy by tracking the prices paid by businesses, the government, and consumers.

Example of the GDP Price Deflator

Typically GDP, expressed as nominal GDP, shows the total output of the country in whole dollar terms. Before exploring the GDP price deflator, it's best to first review how prices can impact the GDP figures from one year to another.

For instance, let's say the U.S. produced $10 million worth of goods and services in year one. In year two, the output or GDP then increased to $12 million. On the surface, it would appear that total output grew by 20% year-on-year. However, if prices rose by 10% from year one to year two, the $12 million GDP figure would be inflated when compared to year one.

In reality, the economy only grew by 10% from year one to year two, when considering the impact of inflation. The GDP measure that takes inflation into consideration is called the real GDP. So, in the example above, the nominal GDP for year two would be $12 million, while real GDP would be $11 million.

The GDP price deflator helps to measure the changes in prices when comparing nominal to real GDP over several periods. 

GDP Price Deflator Calculation

The following formula calculates the GDP price deflator:

GDP Price Deflator = (Nominal GDP ÷ Real GDP) × 100

Benefits of the GDP Price Deflator

The GDP price deflator helps identify how much prices have inflated over a specific time period. This is important because, as we saw in our previous example, comparing GDP from two different years can give a deceptive result if there's a change in the price level between the two years.

Without some way to account for the change in prices, an economy that's experiencing price inflation would appear to be growing in dollar terms. However, that same economy might be exhibiting little-to-no growth, but with prices rising, the total output figures would appear higher than what was really being produced.

GDP Price Deflator vs. the Consumer Price Index (CPI)

There are other indexes out there that also measure inflation. Many of these alternatives, such as the popular CPI, are based on a fixed basket of goods.

The CPI, which measures the level of retail prices of goods and services at a specific point in time, is one of the most commonly used inflation measures because it reflects changes to a consumer's cost of living. However, all calculations based on the CPI are direct, meaning the index is computed using prices of goods and services already included in the index.

The fixed basket used in CPI calculations is static and sometimes misses changes in prices of goods outside of the basket of goods. Since GDP isn't based on a fixed basket of goods and services, the GDP price deflator has an advantage over the CPI. For instance, changes in consumption patterns or the introduction of new goods and services are automatically reflected in the deflator, but not in the CPI.

What this means is that the GDP price deflator captures any changes in an economy's consumption or investment patterns. That said, it’s worth bearing in mind that the trends of the GDP price deflator are usually similar to the trends illustrated in the CPI.

The Bottom Line

The fixed basket of goods used in CPI calculations is static and sometimes misses changes in prices of goods outside of it. Since GDP isn't based on the basket of goods and services and the GDP price deflator automatically covers changes in consumption patterns or the introduction of new goods and services, it is a better indicator of where the economy stands than the CPI.

What is the gross domestic product (GDP)?

GDP is the total monetary or market value of all the finished goods and services produced within a country’s borders in a specific time period. As a broad measure of overall domestic production, it functions as a comprehensive scorecard of a given country’s economic health.

Though GDP is typically calculated on an annual basis, it is sometimes calculated on a quarterly basis as well. In the U.S., for example, the government releases an annualized GDP estimate for each fiscal quarter and also for the calendar year. The individual data sets included in this report are given in real terms, so the data are adjusted for price changes and is, therefore, net of inflation.

What is deflation?

Deflation is a general decline in prices for goods and services, typically associated with a contraction in the supply of money and credit in the economy. During deflation, the purchasing power of currency rises over time.

What is the consumer price index (CPI)?

The CPI is a measure that examines the weighted average of prices of a basket of consumer goods and services, such as transportation, food, and medical care. It is calculated by taking price changes for each item in the predetermined basket of goods and averaging them. Changes in the CPI are used to assess price changes associated with the cost of living.

The CPI is one of the most frequently used measures of inflation and deflation. It may be compared with the producer price index (PPI), which instead of considering prices paid by consumers looks at what businesses pay for inputs.

What happens if consumer price index increases?

When a price index moves from 107 to 110 the rate of inflation is?

What does it mean if the CPI rises from 100 to 105?

What does a consumer price index of 120 mean?