How does the GDP deflator adjust for inflation?

The GDP deflator adjusts for inflation by comparing the current year's GDP to a base year's GDP.

The GDP deflator, also known as the GDP price deflator, is a measure of the level of prices of all new, domestically produced, final goods and services in an economy. It's a ratio of the value of goods and services an economy produces in a particular year at current prices to that of prices in a base year. This ratio helps us understand the extent to which the increase in gross domestic product (GDP) has happened due to either an increase in the production of goods and services, or due to the rise in prices or inflation.

To calculate the GDP deflator, you divide the nominal GDP by the real GDP and then multiply by 100. Nominal GDP is the market value of goods and services produced in an economy, unadjusted for inflation. Real GDP, on the other hand, is nominal GDP, adjusted for inflation to reflect changes in real output.

For example, if a country's nominal GDP in a particular year was £500 billion and the real GDP was £400 billion, the GDP deflator would be (500/400) x 100 = 125. This means that the level of prices increased by 25% from the base year to the current year.

The GDP deflator is a broad measure of inflation and an important tool in economic analysis. It reflects changes in the average price level in the economy and allows economists to compare economic output across years by controlling for the effects of inflation.

Unlike the Consumer Price Index (CPI), which measures the price level of a fixed basket of goods and services, the GDP deflator is not based on a fixed basket of goods and services. The basket in the GDP deflator is allowed to change with people’s consumption and investment patterns. Therefore, the GDP deflator can give a more accurate picture of the inflation rate in the economy.

In conclusion, the GDP deflator is a crucial tool in economic analysis, allowing economists to adjust the GDP for the effects of inflation and compare economic output across different years.