# What does the GDP deflator measure?

As Menzie explained yesterday, it isn’t inflation. Since there still seems to be some controversy about this issue (e.g.,

Reuters ), let me take a stab at it as well.

Rather than walk through the detailed accounts of the U.S. let me invite you to calculate for yourself nominal GDP, real GDP, and the GDP deflator for the economy of Islandia, a pleasant South Pacific locale where they import oil and grow coconuts. In 2007, Islandia produced 500 coconuts, which residents sold to themselves for \$1 each, and imported 1 barrel of oil, which cost \$100. The oil was paid for by borrowing from foreigners.

Ready to calculate GDP? We want the dollar value of domestically produced final goods and services, to wit, the dollar value of the 500 coconuts. Got the answer? Very good. Nominal GDP in Islandia for 2007 was \$500. If you wanted to describe that in real terms, you’d call it 500 coconuts. You don’t count the oil in either nominal or real GDP because Islandia didn’t produce any

oil.

Here are the numbers for 2008. We grew 510 coconuts, sold them for \$1.01 each, and still imported 1 barrel of oil, paying \$125 for it. So nominal GDP was \$515.10 (a 3% increase) and real GDP was 510 coconuts (a 2% increase). The change in the implicit GDP deflator would be the change in the ratio of nominal GDP to real GDP, namely, +1%.

But wait a minute, Islandia’s pundits decry. How can your crummy accounting claim that inflation was only 1%? Last year we bought 500 coconuts and 1 barrel of oil for \$600, but this year if we tried to buy the same thing it would cost us \$630. The inflation rate, they tell you, is obviously 5%, not 1%. You must have intentionally cooked the books, they charge, just to make the economy appear better than it is!

You patiently try to explain that imports aren’t included in GDP, and that’s why the numbers came out the way they did.

But they’re not going to believe you.

Source: econbrowser.com

Category: Forex