Have you ever wondered how inflation is measured? This lesson will compare and contrast two of the indicators used to measure inflation - the consumer price index and the GDP deflator.
GDP Deflator & Consumer Price Index
Economists measure inflation, or changes in the price level, using a price index. The consumer price index (CPI) is an index measuring the level of prices in the economy and comparing them to previous years in order to gauge the level of inflation inside the economy. It's based on a fixed basket of goods that an average person buys each year.
For example, according to this table showing changes in the consumer price index over a 4-year period, the index changed from 100 to 103 between years one and two. That means that prices increased by 3%. The value of an index is that you can easily compare prices across different years, but the consumer price index is not the only indicator that economists have to measure changes in the average level of prices. They also use what's called The GDP deflator.
Remember that GDP, or the gross domestic product, is the market value of all final goods and services produced within a country's domestic borders, and it's usually quoted on an annual basis.
The GDP deflator is a number, similar to the consumer price index, that we can use to deflate, or adjust downward, the gross domestic product and thereby remove the effect of rising prices. What we want to know is how much did our economy really grow because of increased production? We don't want to count increases in prices, and when we use the GDP deflator, we can adjust nominal GDP for inflation.
The formula for the GDP deflator is nominal GDP divided by real GDP
So, the formula for the GDP deflator is nominal GDP / real GDP. For example, if nominal GDP in year one is recorded as $2.2 trillion and the real GDP in the same year is $1 trillion, then the GDP deflator would be 2.2 / 1 = 1.2. We can turn this number into an index by multiplying by 100. In this case, we'd get 120, which we can now compare to another year, so we can find out how much prices rose. If this year's GDP deflator is 1.2 and last year's GDP deflator was 1, then that means prices rose by 20%.
GDP Deflator vs. Consumer Price Index
I said that the consumer price index represents a fixed basket of goods and services that is compared year by year, but the basket never changes. In reality, though, people's tastes and behaviors do change over time, which means that in real life an average person's basket of goods also changes, but the consumer price index assumes no change in the basket of goods.
For example, let's say the consumer price index reflects a basket of goods, including 14% food, 30% housing, and 10% energy, with everything in the basket totaling 100%, of course. This basket is supposed to represent the average person's buying patterns within the economy, so it's a good benchmark for spending. This same basket of goods is used to compare changes in price every single year - even for decades. So, what if the price of energy increased dramatically and people only buy half as much gas? Then, the real basket that the average person buys would be different from the assumed, fixed basket of goods that the government deals with. This poses a challenge to economists, which leads us to favor the GDP deflator.
Unlike the GDP deflator, the consumer price index represents a fixed basket of goods and services
The GDP deflator is a more accurate indicator of inflation because it includes all the goods and services in the economy, so it doesn't have this limitation of a fixed basket of goods. The GDP deflator is considered by economists to be the best measure of changes in the price level of a nation's gross domestic product. However, the CPI continues to be released, and it might even be easier for consumers to understand.
Let's summarize what we've talked about in this lesson. The consumer price index is an index measuring the level of prices in the economy and comparing them to previous years in order to gauge the level of inflation inside the economy.
But economists also use what's called the GDP deflator. The formula for the GDP deflator is as follows: GDP deflator = nominal GDP / real GDP. The GDP deflator is considered by economists to be the best measure of changes in the price level of a nation's gross domestic product and more accurate than the consumer price index because it doesn't depend on a fixed basket of goods like the consumer price index does.