As we have just seen, nominal GDP reflects both the prices of goods and services and the quantities of goods and services the economy is producing. By contrast, by holding prices constant at base-year levels, real GDP reflects only the quantities produced. From these two statistics, we can compute a third, called the GDP deflator, which reflects the prices of goods and services but not the quantities produced.
The GDP deflator is calculated as follows:
GDP deflator = Nominal GDP X 100. Real GDP
GDP deflator a measure of the price level calculated as the ratio of nominal GDP to real GDP times 100
Because nominal GDP and real GDP must be the same in the base year, the GDP deflator for the base year always equals 100. The GDP deflator for subsequent years measures the rise in nominal GDP from the base year that cannot be attributable to a rise in real GDP.
The GDP deflator measures the current level of prices relative to the level of prices in the base year. To see why this is true, consider a couple of simple examples. First, imagine that the quantities produced in the economy rise over time but prices remain the same. In this case, both nominal and real GDP rise together, so the GDP deflator is constant. Now suppose, instead, that prices rise over time but the quantities produced stay the same. In this second case, nominal GDP rises but real GDP remains the same, so the GDP deflator rises as well. Notice that, in both cases, the GDP deflator reflects what's happening to prices, not quantities.
Let's now return to our numerical example in Table 22-2. The GDP deflator is computed at the bottom of the table. For year 2001, nominal GDP is $200, and real GDP is $200, so the GDP deflator is 100. For the year 2002, nominal GDP is $600, and real GDP is $350, so the GDP deflator is 171. Because the GDP deflator rose in year 2002 from 100 to 171, we can say that the price level increased by 71 percent.
The GDP deflator is one measure that economists use to monitor the average level of prices in the economy. We examine another—the consumer price index—in the next chapter, where we also describe the differences between the two measures.
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