In the world of economics and finance there are many different terms and indices that help us better understand what is happening in the markets. However, there are so many that it is sometimes confusing. Today's article is intended to explain what is the GDP deflator, what is it for and how is it calculated, since it usually causes a lot of confusion.
As usual, it is important understand some concepts to be able to carry out the calculation of the indices. The case of the GDP deflator is no exception, as it is closely related to inflation and deflation. For this reason, we will also explain what these terms are and some more that will help us understand what the GDP deflator is.
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GDP Deflator: Concepts
Before explaining what exactly is the GDP deflator, there are some concepts that we must know to understand it well. We will not be able to understand the usefulness that this index gives us if we do not know what other elements are that influence its calculation. Among them are the terms of deflation, inflation, deflator and GDP, Of course.
The word deflator comes from Latin and translates as “to deflate”. It is an index that is normally used to solve economic problems that are related to the estimation of some magnitudes at the economic level. In this world, a very complicated task is to evaluate how much the economy can grow, that is, the value that goods and services can reach. The main method to measure this growth is inflation, which we will explain a little later.
When evaluating what real growth would be and not only its value, it is essential to use real GDP (gross domestic product). This index only takes into account the quantities that have actually been produced. To achieve this, the effect of price fluctuations must be removed from the equation. Therefore, an adjustment is required, for which the deflator is responsible. Therefore, a deflator is basically a price index. It can be compound or simple and allows dividing between quantity and price components.
What is GDP?
Let us now explain what GDP is. These acronyms stand for "Gross Domestic Product." It is a macroeconomic magnitude that reflects the value of the production of goods and services at the monetary level of a country during a certain period of time. Generally, it is usually contemplated on a quarterly or annual basis.
It is important that we know differentiate nominal GDP from real GDP. The first refers to what its value would be at market price. In addition, this adds the effect of inflation. On the other hand, real GDP refers to the value of constant prices. In this case, the effect of inflation is eliminated.
We should not confuse GDP with IPC (Consumer Price Index). This indicator is responsible for measuring which increases the prices of standard products. These are, let's say, the average basket of a family, whatever the sector.
inflation and deflation
Now we only have to clarify the concepts of inflation y deflation. We've already heard the first one a million times in the news, but what exactly is it? As well, Inflation is an economic process that takes place in a sustained and generalized way in a country when the prices of goods and services increase.
Instead, deflation occurs when there is a general drop in prices in the country, usually caused by a reduction in the money supply. That is to say: The currency in question increases its value, which has as a consequence an increase in its value. purchasing power.
As we have mentioned before, the GDP deflator measures the changes that occur in this index. Therefore, It indicates in a general way both inflation and deflation of an economy.
What is the GDP deflator and what is it used for?
Now that we have explained the concepts related to the GDP deflator, we are going to comment on what exactly this index is. It is mainly used for calculate the price changes that occur in the gross domestic product. That is to say: The GDP deflator is an index that calculates the average value of the prices that occur in a country during a given period of time. This helps us to find out the economic growth of the country in question.
It is important to note that the GDP deflator does not use only an average cost, as the CPI does, but uses the prices of all goods and services. For this reason we can say that is an index that performs a real calculation, while the CPI uses a statistical calculation.
How is the GDP deflator calculated?
After understanding what the GDP deflator is, let's see how it is calculated. Surely you already know that the main function of Central Banks is to preserve economic stability, that is, of prices. To do this, they set a target for inflation, such as not exceeding 2%. Since inflation causes an increase in prices, it is necessary to obtain an indicator that eliminates the effect caused by this process. If we manage to ignore inflation, we will know if an economy is really growing or if it is only increasing prices. This is what the GDP deflator shows us. To calculate it, we simply have to apply this formula:
GDP deflator = (nominal GDP / real GDP) x 100
In conclusion we can say that the GDP deflator is not useful to measure what would be the quality of life of a country. The purpose of this index is measure the purchasing power of that same country. Therefore, it is a tactical index to calculate changes in GDP and prices, whether we are going through a period of inflation or deflation.