The GDP deflator is a fudge factor that allows us to compare an economy's Gross Domestic Product in two or more different years. It also allows us to accurately assess an economy's real growth rate over time. It does this by providing a compensating factor that backs inflation out of the GDP results.
The Problem the GDP Deflator Helps Solve
One problem with trying to understand an economy's performance over a period of years is that price inflation skews results. For example, if over the past year your wages increased by 7 percent, but now as a result of price inflation it costs 10 percent more to buy goods, you've actually lost buying power. Your own personal economy isn't 7 percent greater; it's about 3 percent less.
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Nominal vs. Real GDP
The same concept holds true for GDP, which economists define as the total market value in a given year of everything produced within that country's borders, plus exports less imports. For example, consider a GDP that's growing at the rate of 7 percent annually, but during the same period price inflation grew at the rate of 10 percent. Although what economists call the "Nominal GDP" grew by 7 percent, the economy's "Real GDP" actually shrank by around 3 percent. Comparing nominal GDPs doesn't tell us very much.
GDP Inflator Formulas
One way of overcoming this problem is to establish a base year for annual GDP calculations, then back inflation out of the nominal GDP numbers in later years by using a compensating inflation rate factor, the "GDP Deflator."
The GDP Deflator equals nominal GDP divided by real GDP times 100
If nominal GDP equals $600 billion and real GDP equals $500 billion, then the GDP Deflator equals 120.
When the GDP Deflator is known, it can be used to calculate Real GDP from Nominal GDP:
Real GDP equals Nominal GDP divided by GDP Deflator
The GDP Deflator and Growth Rate Comparisons
Comparing the growth rates of two economies requires using the GDP inflator to differentiate between real and nominal growth in successive years.
For example, using the GDP Deflator allows you to understand that real Chinese GDP in 2014 grew at the rate of 7.4 percent. Compared to the real U.S. growth rate in 2014 of 2.4 percent, it seems robust.
However, a static comparison of GDPs in a single year doesn't tell you all you need to know. An analysis of real Chinese GDPs in several different years shows that Chinese growth rates declined year over year from 2009 through 2014, while the U.S. real GDP increased year over year for the same period. China's economy seems to be slowing down while the U.S. economy is speeding up.
By comparing real GDP growth year over year, economists can more accurately determine a country's long-term economic trend and more accurately compare the growth rates of different economies. The GDP Deflator gives economists a convenient way of doing this.