What is the GDP Price Deflator?

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Definition:

The GDP price deflator is a measurement of price changes that allows for the adjustment of economic statistics to account for the effects of inflation.

🤔 Understanding GDP price deflators

Gross domestic product (GDP) is a macroeconomic statistic that measures the value of everything produced within a country’s borders during a quarter or year. However, inflation (the general tendency for all prices to increase over time) is typically responsible for part of any rise in GDP. The GDP price deflator — also called the GDP implicit price deflator or simply the GDP deflator — allows the effects of inflation to be removed from the measurement. Any increase in GDP after applying the GDP price deflator is considered real economic growth. The GDP price deflator is similar to the consumer price index (CPI), except that it adjusts the value of actual expenditures rather than that of a basket of goods.

Example

In the fourth quarter of 2020, the United States economy produced a gross domestic product (GDP) of $20.9T per year. One year later, that figure was up to $23.0T. However, that 10.04% growth in GDP is a combination of increased productivity and increased prices.

To isolate that improved productivity, we would need to adjust for the rising prices. Looking at the GDP implicit price deflators for 2020 and 2021, the U.S. Bureau of Economic Analysis (BEA) provides index values of 114.44 and 121.19, respectively.

Dividing those index values generates the rate attributable to inflation (5.9%). And multiplying the 2020 value by that inflation rate transforms the 2018 GDP into 2021 dollar values ($20.9T x 1.059 = $22.1T). That means that of the $2.1T increase in GDP, about $1.2T was due to inflation, and $900B was real growth.

Takeaway

The GDP deflator is like adjusting a kid’s height for their age…

When you look at a classroom full of 10-year-olds, it’s easy to pick out which children are tall and which are not. But consider knowing a child’s height without knowing their age. It would be difficult to express an opinion about whether 4’ 7” is tall or not. That might be a tall seven-year-old or a short 16-year-old. To know what that number really means, you need context. A height index (GDP deflator) and the age of the child (number of years from the base year) would allow you to compare the child’s height (GDP) to general growth rates (inflation).

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What is the GDP Price Deflator?

The GDP price deflator is an adjustment to a country’s gross domestic product (the market value of all the final goods produced inside an economy). It allows analysts to understand whether an increase in economic output indicates an improved economy, or merely an increase in prices.

The GDP price deflator is the ratio of the value of things purchased in one year versus the cost of those same goods in a base year, excluding imports. Comparing the price level between years allows analysts to estimate the rate of inflation or deflation (a general decrease in the prices of goods) in the economy during a period of time.

What is the purpose of the GDP price deflator?

The purpose of the GDP price deflator is to adjust the value of economic output for the effects of inflation (the general tendency for prices to increase over time). Policymakers use real GDP (a GDP figure adjusted for inflation) to understand the state of the economy.

If the real GDP falls for two consecutive quarters, it is called a recession. During a recession, the federal government may employ expansionary fiscal policy (increasing spending) or monetary policy (decreasing interest rates) to stimulate the economy. Some government programs and employment contracts may use the GDP price deflator to adjust the amount of benefits or salaries.

How do you calculate the GDP price deflator?

The Bureau of Economic Analysis (BEA) estimates the GDP deflator each quarter. The BEA currently uses 2012 as the base year (the year to which other years are compared). Calculating the GDP price deflator requires dividing the gross domestic product (GDP) in the current year (called nominal GDP) by the value of those same products if they were sold at 2012 prices (called real GDP). The result is multiplied by 100 to convert the decimal into an index value with a base year value of 100.

GDP deflator = Nominal GDP / Real GDP x 100

The concept may be easier to understand with an example. Imagine that an economy produces only two products, t-shirts and sweatpants. The total value of all the t-shirts and sweatpants made in this fictional country would be its GDP. You want to know how this economy has changed between two years. But, it’s hard to tell if things are improving because prices and volumes of production have both changed. It might be helpful to calculate the GDP deflator. Here is the data:

| Year | T-Shirt Sales | T-Shirt Price | Value of T-Shirts | Sweatpants Sales | Sweatpants Price | Value of Sweatpants |

| 2022 | 10,000 | $10 | $100,000 | 12,000 | $15 | $150,000 |

| 2012 | 12,000 | $8 | $96,000 | 11,000 | $12 | $132,000 |

We can determine the nominal GDP right away. It’s the value of the t-shirts plus the value of the sweatpants ($100,000 + $180,000 = $280,000). Now we need to figure out the real GDP. To do so, we need to multiply the 2022 sales by the 2012 price.

| Year | T-Shirt Sales | T-Shirt Price | Real Value of T-Shirts | Sweatpants Sales | Sweatpants Price | Real Value of Sweatpants |

| 2022 | 10,000 | $8 | $80,000 | 12,000 | $12 | $144,000 |

Doing so generates a real GDP of $80,000 + $144,000 = $224,000. Now we can calculate the GDP deflator:

2022 GDP deflator = $280,000 / $244,000 x 100 = 114.75

Is the GDP price deflator the same as the inflation rate?

A GDP price deflator is a price index, which explains how the value of goods in one year compares to another. The base year is set at 100, and all other years are converted into numbers that are easy to compare to the base year.

For example, a price deflator of 105 is five percent above the base year. And a value of 247 is 147% above the base year. Because inflation is defined as the change in price over time, the GDP deflator is a measure of price inflation. The percentage change in the GDP deflator between any two years generates one estimate for the inflation rate between those years. For instance, the GDP deflator for the fourth quarter of 2021 was 121.188, while the value for the fourth quarter of 2020 was 114.439. Dividing the change in those numbers by the 2020 value generates the rate of inflation between the periods.

2021 inflation rate = (121.188 – 114.439) / 114.439 = 0.058 = 5.8%

However, the GDP deflator is only one of many measures of how prices change over time. The most popular standard is the consumer price index (CPI), which is widely considered to be the official measure of inflation.

Other indexes include the producer price index and the personal consumption expenditure price index. Each method of tracking price changes is a little different, and each produces a slightly different number. But they all measure inflation in their own way.

What is the difference between the GDP price deflator and CPI?

The consumer price index (CPI) is a commonly used measure of inflation that is produced by the U.S. Bureau of Labor Statistics (BLS). Many government agencies and private corporations use the CPI as the official rate of inflation for the United States. They use the CPI to adjust program benefits and salaries so that recipients and employees don’t lose purchasing power due to rising costs. For example, the Social Security Administration makes cost-of-living adjustments each year using the CPI. In January 2022, the benefits increased by 5.9%.

The CPI and GDP deflator usually generate similar inflation estimates, although the GDP deflator tends to be slightly lower. However, the two measures use different approaches to arrive at their values. The GDP deflator looks at all of the products produced in an economy during the year. It then applies the 2012 prices to the quantity of goods sold.

For example, the 2022 GDP price deflator would multiply the cost of a car in 2012 by the number of vehicles manufactured in the U.S. in 2022. By doing this for all of the goods in the economy, the 2022 output is expressed in 2012 dollars. In effect, the process deflates the gross domestic product (GDP) of the country to account for price changes.

Alternately, the CPI uses a sample of products from the economy to estimate the general price trend. This basket-of-goods approach follows the costs of products through time. To understand the method, imagine having a grocery list that you buy over and over. Each month, you go to the store and purchase precisely the same items every time. Because the items in your cart are not changing each shopping trip, you can attribute any difference in the bill to changes in prices.

Importantly, inflation is a measure of the general price of all goods in the economy. If one product was on sale last month, or if a freeze in Florida caused the cost of oranges to go up, those individual product price increases are not inflation. But if the total of all the price increases exceeds the price reductions in other products, then inflation exists. It is for this reason that the BLS uses a basket of goods that covers many sectors and products.

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This information is educational, and is not an offer to sell or a solicitation of an offer to buy any security. This information is not a recommendation to buy, hold, or sell an investment or financial product, or take any action. This information is neither individualized nor a research report, and must not serve as the basis for any investment decision. All investments involve risk, including the possible loss of capital. Past performance does not guarantee future results or returns. Before making decisions with legal, tax, or accounting effects, you should consult appropriate professionals. Information is from sources deemed reliable on the date of publication, but Robinhood does not guarantee its accuracy.

Robinhood Financial LLC (member SIPC), is a registered broker dealer. Robinhood Securities, LLC (member SIPC), provides brokerage clearing services. Robinhood Crypto, LLC provides crypto currency trading. All are subsidiaries of Robinhood Markets, Inc. (‘Robinhood’).

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