What Is the GDP Price Deflator and Its Formula?

What Is the GDP Price Deflator?

The gross domestic product (GDP) price deflator is a formula that measures the amount that the real value of an economy's total output is reduced by inflation. The GDP deflator formula takes into account the value of all final goods including exports. It does not factor in the prices of imports.

The GDP deflator formula is used by the Bureau of Economic Analysis (BEA). It helps economists track more accurately how the economy is faring over time, while taking inflation into account.

Formula and How to Calculate GDP Price Deflator

The following formula calculates the GDP price deflator:

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

To calculate the GDP price deflator, divide the nominal GDP by the real GDP and multiply the result by 100. Nominal GDP is the total value of goods and services produced during a specific period less the value of products made during production. Real GDP refers to the value of goods and services produced in a year and adjusted for inflation.

Understanding the GDP Price Deflator

GDP represents the total output of goods and services. But it doesn't factor in the impact of inflation or rising prices. The GDP price deflator addresses this by showing the effect of price changes on GDP. The price deflator formula establishes a base year and compares current prices to the base year prices.

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

How the Price Deflator Is Used

Some companies use the GDP price deflator to adjust their contract payments.

The GDP price deflator closely resembles another economic metric—the GDP Price Index, which also measures the rise in prices of goods and services, including exports.

However, the two metrics are calculated differently.

Data for the GDP price deflator is calculated and reported by the BEA every quarter based on data reported every month. As of the third quarter of 2023, the GDP price deflator increased by 3.3%, compared to an increase of 1.7% during the second quarter of the year.

Benefits of the GDP Price Deflator

The GDP price deflator helps identify how much prices have inflated over a specific time. This is important because comparing GDP to a previous year can be deceptive if there's a change in the price levels between both periods.

Without some way to account for the change in prices, an economy that experiences price inflation would appear to be growing in productivity when it is really growing only in dollar terms.

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

Other indexes measure inflation. Many of these alternatives are based on a fixed basket of goods. These include the consumer price index (CPI), which measures the level of retail prices of goods and services over time.

The CPI is an important inflation measure because it reflects real changes to a consumer's cost of living. However, all calculations based on the CPI are direct, which means 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. 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.

This means that the GDP price deflator captures any changes in an economy's consumption or investment patterns. That said, the trends of the GDP price deflator are usually similar to the trends illustrated in the CPI.

Example of the GDP Price Deflator

GDP, often referred to as nominal GDP, shows the total output of the country in whole dollar terms. That can be deceptive.

For example, say the U.S. produced $10 million worth of goods and services in year one. In year two, the output or GDP 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 considers inflation is called the real GDP. So, in the example above, the nominal GDP for year two would be $12 million, while the country's real GDP would be $11 million.

The Bottom Line

The CPI is important because it tracks the changes in the prices of a fixed basket of goods that most American consumers use regularly. But it omits changes in prices of goods outside of that basket.

GDP is the total of all goods and services produced in the economy, and the number is tracked from year to year as a way to determine the health of an economy. In this case, inflation is relatively irrelevant and even confuses the issue.

The GDP price deflator separates the inflation factor from GDP so that each element can be analyzed separately.