Implicit GNP Price Deflator

There are price deflators, like...things that would bring down something's price. Think: two-day-old sushi. Or Christmas ornaments on December 26th. Or a prize show dog that suddenly loses all it’s hair.

But that's not the kind of price deflator we have in mind here.

The GDP price deflator is a measure of prices for goods and services produced within a country for a period of time. It's a way to track inflation.

Example time.

Snowhaven is a tiny country located to the north of Greenland. The nation boasts 120 residents, each of whom makes a living from the production and export of ice sculptures. You're an Econ PhD student working on a thesis. Your roommate threw a party the day before you were scheduled to declare your thesis topic. You don't remember much, but somehow you ended up with a thesis topic centered on the economy of Snowhaven.

You start your research. First step, calculate how big Snowhaven's economy is. Simple stuff. To measure economic output, you use GDP, or Gross Domestic Product, a broad measure of economic production. See: GDP. You calculate that figure by adding up the value of all the goods and services produced by an economy during a period of time. In Snowhaven, where everyone just makes ice sculptures, you're dealing only with the value of all the ice sculptures they make.

In a more complex economy, like the U.S., you're dealing with a lot more things. So all the value of ski-doos and juicers and Oreos that get made in a year, as well as the value of all the yoga classes and foot massages...gets added up. Notice that the word "value" keeps coming up. You don't count the number of goods made, or the number of services rendered. You count the value of the goods and services. Like...the dollar value. If you just counted the number of goods, then making a bar of soap would count the same as making a passenger jet. The soap is one thing. The jet is one thing. But obviously more goes into making the jet. A bunch more people have to work a lot more to get that jet made. It should count more in GDP. So...to give everything the proper weighting in the GDP figure, the currency value of the stuff gets added together. The soap contributes 50 cents to GDP. The jet contributes $380 million.

But there's an issue that comes up with this method. GDP gets impacted by price changes. Meaning that inflation gets counted as growth. Prices rise, GDP rises. Whether or not actual output goes up.

This year, the people of Snowhaven made 20,000 ice sculptures, which sold for an average price of $1,000 each. $1,000 times 20,000...$20 million. GDP for the year was $20 million. Next year, they also make 20,000 sculptures. But there’s a wave of high-class art galas in Monaco that needs ice sculptures...and that drives prices higher. Average price rises to $1,100. Plug that into the GDP equation. Total GDP: $22 million. 10% GDP growth. But all of that was from inflation.

Ideally, as an economist, you want to be able to tell how much changing prices contribute to GDP growth. That way, you can get an accurate picture of what's going on in the economy without inflation mucking up the situation. For that reason, there are actually two GDP measures. There's nominal GDP, i.e. the number we just figured out. It's the raw number that includes the price changes. And then there's real GDP. It's an adjusted number, where the impact of price changes get stripped out.

Here’s where the implicit GDP price deflator comes in. It represents the ratio between nominal GDP and real GDP. It shows the impact that inflation had on GDP that year.

So Snowhaven has nominal GDP of $22 million for the year. But $2 million of that came from price changes. The country's real GDP totals $20 million. Nominal GDP over real GDP...$22 million over $20 million. The implicit GDP price deflator for the year is 1.1.

A number above 1 on the deflator figure means prices went up during the period. In other words, inflation. The higher the number, the higher the rate of inflation.

A number below 1 means real GDP was higher than nominal GDP, and indicates a drop in general prices. Deflation.

Like when your suddenly bald, former prize show dog also develops a painful infectious skin disease and starts to show early signs of rabies...