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Economic Theory

The GDP deflator. As we have just seen, nominal GDP reflects both
the prices of goods and services and the quantities of goods and services
the economy is producing. By contrast, by holding prices constant at base-
year levels, real GDP reflects only the quantities produced. From these two

statistics, we can compute a third, called the GDP deflator, which reflects
the prices of goods and services but not the quantities produced. The GDP

deflator is calculated as follows:

Nominal GDP
GDP deflator   100 %. (3.10)
Real GDP

Because nominal GDP and real GDP must be the same in the base

year, the GDP deflator for the base year always equals 100. The GDP
deflator for subsequent years measures the rise in nominal GDP from the
base year that cannot be attributable to a rise in real GDP.
The GDP deflator measures the current level of prices relative to the

level of prices in the base year. To see why this is true, consider a couple
of simple examples.
First, imagine that the quantities produced in the economy rise over

time but prices remain the same. In this case, both nominal and real GDP
rise together, so the GDP deflator is constant. Now suppose, instead, that
prices rise over time but the quantities produced stay the same. In this
second case, nominal GDP rises but real GDP remains the same, so the

GDP deflator rises as well. Notice that, in both cases, the GDP deflator
reflects what’s happening to prices, not quantities.

5. GDP and Well-Being
It is common to use GDP as a measure of economic welfare or

standard of living in a nation. When comparing the GDP of different
nations for this purpose, two issues immediately arise. First, the GDP of a
country is measured in its own currency. Thus, comparing GDP between

two countries requires converting to a common currency. A second issue is
that countries have very different numbers of people. So, if we are trying
to compare standards of living across countries, we need to divide GDP by
population and find Per capita GDP, the main indicator of the average

person’s standard of living:

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