The
GDP deflator is one way in which
inflation is measured.
Inflation is the continued increase of prices over time. Despite various policies that have effects on the level of
inflation it is always caused by
printing money.
The GDP deflator is derived by
dividing the total
Gross Domestic Product at
current prices by total
Gross Domestic Product at
constant prices. The
data on
current prices usually comes, at least partially, from the
Consumer Price Index. The
data used for
constant prices is taken from a
base year. Which year is being used currently depends upon which country the GDP deflator is being calculated in.
GDP can be measured using the
expenditure approach which examines the
total spending on
goods and services within and
economy. Alternately,
GDP can be measured using the
income approach which looks at the amount of money brought in from selling
goods and services. Since somebody pays a dollar for each dollar that someone gets, the two values are equal. This is what people mean by the
circular nature of spending.
GDP measured in either of the above ways is then re-valued according to the constant set of
prices from the
base year. The value of GDP in present dollars is then divided by the value of GDP in the dollars of the base year. This gives an indication of the extent to which the value of the dollar has changed and hence the
rate of inflation.
The figure determined by the above system is expressed as an
index. This means that the figure for the
base year is given a value of 100. Values of the
GDP deflator for subsequent years are calculated to show their value relative to this base.
Unlike the
Consumer Price Index, which only examines the changes in
prices for a particular basket of goods, the
GDP deflator is supposed to measure changes in prices across the entire
economy. This may make it a more accurate measure of the
rate of inflation. It must be remembered, however, that the
Consumer Price Index is used to calculate the value of the current year
prices. This passes on some of the error in the
CPI to the
GDP Deflator.
In any case, it is the general consensus among
economists is that both of these
tools
overstate the
rate of inflation slightly. Having an accurate measure of the
rate of inflation is extremely important since
price stability is one of the two fundamental goals of a
central bank. The way this is accomplished, using
monetary policy, is by controlling the
interest rate used by the
central bank. Since raising this rate cuts
inflation but stifles business, a balance must always be found between the two. People disagree where this balance should lie, but an accurate measure of the
rate of inflation, which the
GDP deflator tries to provide, is vital in any case.