*DAY #15 10.04.2020*
*TOPIC – GDP Deflator*
To understand GDP Deflator, first understand Gross Domestic Product at current year prices i.e. Nominal Gross Domestic Product and Gross Domestic Product at base year prices i.e. Real Gross Domestic Product.
Nominal Gross Domestic Product - The market value (on the price of current year) of the final production of goods and services within a country produced in a particular year.
Real Gross Domestic Product - The market value (on the price of base year) of the final goods and services produced within a country’s domestic territory in a particular year. GDP adjusted for changes in the price level, using prices from a base year (constant prices) instead of “current prices” used in nominal GDP; real GDP adjusts the level of output for any price changes that may have occurred over time
Base Year - A base year is the first of a series of years in an economic or financial index. It is typically set to an arbitrary level of 100. New, up-to-date base years are periodically introduced to keep data current in a particular index. Any year can serve as a base year, but analysts typically choose recent years. This is the year which is used for comparison in the determination of price changes using the GDP deflator price index; the deflator in a base year is always equal to 100.
Current Year Prices - The prices at which goods and services are sold in a country in a particular year; current prices are used when calculating Nominal GDP.
Constant Prices - Constant prices are in real value, i.e. corrected for changes in prices in relation to a base line. The constant prices from a base year that are used to calculate real GDP in other years; this allows for a more accurate measure of how a country’s actual output changes over time, because using constant prices cancels out any changes in the price level between years.
GDP deflator – The GDP deflator is calculated by dividing nominal GDP by real GDP and multiplying by 100. The GDP deflator measures price inflation / deflation in an economy. It is calculated by dividing nominal GDP by real GDP and multiplying by 100. In other words, GDP deflator is a price index used to adjust nominal GDP to find real GDP; the GDP deflator measures the average prices of all finished goods and services produced within a nation’s borders over time.
HOW TO CALCULATE THE GDP DEFLATOR
To calculate the GDP deflator, we can follow a three-step process:
(1) calculate nominal GDP,
(2) calculate real GDP, and
(3) calculate the GDP deflator.
We will calculate the above aggregates with the given values.
WHEAT
|
RICE
| |||
Quantity
|
Price
|
Quantity
|
Price
| |
2015
|
2
|
100
|
1
|
200
|
2016
|
3
|
150
|
2
|
230
|
2017
|
4
|
200
|
3
|
300
|
1. CALCULATE NOMINAL GDP -
Nominal GDP is defined as the monetary value of all finished goods and services within an economy valued at current prices. This we can calculate by multiply the quantity of all goods and services produced with their respective prices and add them all up.
To give an example, think of an economy that only produces wheat and rice. The table shows the quantity produced and prices of both goods for three consecutive years (2015, 2016, and 2017). If we calculate nominal GDP as described above, we find that for the year 2015, it amounts to Rs.400 (2*100 + 1* 200). Meanwhile for 2016 nominal GDP is Rs. 910 (3*150 + 2*230) and for 2017 nominal GDP amounts to Rs. 1700 (4*200 + 3*300).
2. CALCULATE REAL GDP -
Real GDP shows the monetary value of all finished goods and services within an economy valued at constant prices (Base Year). That means, we choose a base year and use the prices of that year to calculate the values of all goods and services for all the other years as well. This allows us to eliminate the effects of inflation.
In the above given years, we assumes 2015 as base year. Thus, the reference prices of wheat and rice are 2.00 and USD 1.00, respectively. Starting from there, we can now calculate real GDP for all three years. In 2015 real GDP amounts to Rs. 400 (2*100 + 1* 200). Note that in the base year, real and nominal GDP are always the same because we use the same prices when calculating them. Meanwhile for 2016 Real GDP is Rs. 530 (2*150 + 1*230) and for 2017 Real GDP amounts to Rs. 700 (2*200 + 1*300). If you compare these numbers to the numbers we calculated above, you can already see that real GDP doesn’t grow quite as much as nominal GDP.
3. CALCULATE GDP DEFLATOR -
Now we can calculate the GDP deflator. To do this, we divide nominal GDP by real GDP and multiply the result with 100. This gives us the change in nominal GDP (from the base year) that cannot be attributed to changes in real GDP. Check out the formula below:
Going back to our example, we can quickly see that the GDP deflator for 2015 is 100 ([400/400]*100). The GDP deflator for the base year will always be 100 because nominal and real GDP have to be equal.
However, for the year 2016, the GDP deflator is 171.69 ([910/530]*100). That means, from 2015 to 2016, the price level has increased by 71.69% (171.69 – 100).
The GDP deflator for the year 2017 is 242.85 [(1700/700)*100], which reflects a price level increase of 142.85% compared to the base year. If we take base year as 2016, then the GDP deflator for the year 2017 is 141.66 [(1700/1200)*100], which reflects a price level increase of 141.66% compared to the base year.
· Deflator
can be calculated for any aggregates of National Income.
SOME QUESTIONS -
What happens when GDP deflator increases?
An increase in
nominal GDP may just mean prices have increased, while
an increase in real GDP definitely means
output increased. The GDP deflator is a price index, which means
it tracks the average prices of goods and services produced across all sectors
of a nation's economy over time.
What affects GDP deflator?
The GDP price deflator measures
the changes in prices for all of the goods and services produced in an economy.
... However, as GDP rises and falls, the metric doesn't consider the
impact of inflation or rising prices on the GDP results.
What does a GDP deflator of 100 mean?
Like the consumer price index (CPI),
the GDP deflator is a measure of price inflation/deflation with
respect to a specific base year; the GDP deflator of the base year
itself is equal to 100
Does inflation affect GDP?
Nominal GDP measures the value of
output produced during a period using the prices of that time period. But the
general level of prices can rise due to inflation, leading to an increase
in nominal GDP even if the volume of goods and services produced is
unchanged. This is where real GDP comes in.
Can GDP deflator be more than 100?
No, a deflator greater than
100 means that the price level is higher than in the base year.
It doesn't mean that inflation is still occurring. In fact, you could be
experiencing deflation after a period of inflation and if prices today are
still higher than the base year, have the deflator be
above 100.
Can GDP deflator be less than 100?
Is it possible to have a GDP
deflator of less than 100? A. Yes, it would indicate a year when
prices were lower than in the base year. Yes, it would indicate a
year when prices were lower than in the previous year.
Reference Videos
GDP Deflator
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Regards
Dr. Asad Ahmad
KV IIM, Lucknow
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