AP, IB, and College Microeconomic and Macroeconomic Principles 

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The CPI and the GDP Deflator – AP/IB/College

GDP Deflator and CPI

Updated 3/16/2017 Jacob Reed
What is the difference between the GDP Deflator and the CPI?
The most commonly used measure of inflation is the CPI (Consumer Price Index). It tracks price changes in about 80,000 different goods and services bought by a typical urban household. The CPI indicates the impact of inflation on average consumers.

Deflated Baloon

The GDP deflator tracks price changes on all goods and services throughout the entire economy and not just those purchased by average consumers. The GDP deflator is a more comprehensive measure of price levels but might not accurately reflect inflation’s impact on average citizens. 

Real vs Nominal GDP
Nominal values are not adjusted for inflation. Real values have been adjusted for inflation. Multiply the prices times the quantities for all goods and services produced within an economy, then add all the values together and you get the nominal or real GDP (depending on which year’s prices are used). 

To calculate nominal GDP, current year prices and current year quantities are both used. Take a look at the chart below which shows the prices and quantities of production for a country that produces nothing but apples and bananas:

In 1980, the nominal GDP for this country was $500. ($0.25 x 1000) + ($0.50 x 500) = $500. In 2017, the nominal GDP was $3000. ($1 x 1500) + ($1.5 x 1000) = $3000.

The dramatic increase in nominal GDP is somewhat misleading because there were also dramatic price increases between 1980 and 2017. To get a more accurate picture of what happened to this country’s output calculate and compare real GDP (adjusting for inflation) for both years.

​To calculate real GDP, the base year prices and current year quantities are used.  Using the numbers above, the 1980 Real GDP is still $500 because the base year and current year are the same. The real GDP for 2017 is $875. Comparing real GDP between years is a better reflection of the true change in an economy’s output. 

GDP Deflator Chart

Calculating and Using GDP Deflator
The GDP deflator is an index that tracks price changes from a base year. To calculate the GDP deflator, the formula is Nominal/Real x 100.

In the example above the GDP Deflator for 1980 is 100 ($500/$500 x 100 = 100). The GDP deflator for the base year is always 100.  The GDP deflator for 2017 is 342.86 ($3000/$875 x 100 = 342.86).

To convert nominal value to real values the formula is Nominal/Deflator x 100. So if the nominal GDP is $1200 and the GDP Deflator is 150, the real GDP will be $800 ($1200/150 x 100 = $800).

Calculating and Using a Consumer Price Index
The consumer price index tracks price changes in a market basket of goods instead of all goods within an economy. To calculate the index, the quantities will never change but you calculate the value of that basket in both the base year’s prices and the current year’s prices. Then the formula is Current Year/Base Year x 100. 

CPI Chart

​The value of this market basket in the base year is $12. ($0.5 x 10) + ($0.50 x 5) + ($0.25 x 18) = $12. The value of the market basket in the current year is $17. ($0.75 x 10) + ($1x 5) + ($0.25 x 18) =$17.
That means the CPI for 2017 is 141.67 ($17/$12 x 100).

To convert a nominal value to a real value the index is used in the same way the deflator is used. The formula is Nominal/CPI x 100. So a Television that cost $100 in 2017 would cost $70.59 ($100/141.67=$70.59) in 1990. 

Inflation from CPI or Deflator
To calculate the amount of inflation between two deflators or CPIs, you can use the formula for calculating percentage change. That formula is (new-old)/old x 100. If the CPI went from 125 to 150, the amount of inflation would be 20%. 150-125/125 x 100= 20%.

Up Next: 
Review Game: CPI and Deflator Calculations
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