GDP Deflator and Measuring Inflation
January 11th, 2009 at 2:47 pm - by admin
One of the most important topics in economics - especially during hard times and international political unrest - is that of inflation. Inflation is quite simply, an increase in the overall level of prices - a situation which, overtime, reduces the value of individuals’ savings.
Inflation is linked to government and central bank fiscal and monetary policy, it’s linked to laws such as mandatory reserve ratios at chartered banks and other policies. Monetarists claim a synonymous bond between inflation and the size of the money supply, Keynesians and other economists usually link inflation to a number of indicators and factors - obviously, distinct beliefs about inflation and its importance, meanings, and associated variables vary wildly.
Uncertainty about inflation causes investors to reduce investment, individuals to reduce saving, and lack of available goods due to hoarding.
As a society, the Western world employs central banks - the Bank of Canada, the Federal Reserve, and a number of other authorities - to attempt to keep the rate of inflation low (less than 5 per cent, generally), control any risk of deflation, and otherwise manage monetary policy. Open market operations, reserve requirements and other factors are tools used by these authorities to control inflation. This supports the idea that we really care about inflation - and in fact, a number of studies done by the inflation expert, Robert Schiller, demonstrate public perception of inflation as being very high.
Schiller measured the number of times economic terms arose in the mainstream Nexis-indexed media, finding that in the last 2 years (from the time of the study), the term “inflation” showed up over 250,000 times - followed by unemployment at 160,000 and productivity at 100,000. Schiller’s studies on public perception of inflation followed with a number of “agree/disagree” tests with questions such as:
Do you agree that preventing high inflation is an important national priority, as important as preventing drug abuse or preventing deterioration in the quality of our schools?
84 per cent of the general public agreed with that question, compared to only 18 per cent of economists. Questions like
Do you agree with the following statement? “If the government were to make a mistake next year, such as printing too much money, and creates prices that are 20% higher than they are today, I think that they should try to reverse their mistake, and bring prices back down where they are today.”
Had 68 per cent of the general public agreeing, with roughly zero per cent of the economists interviewed. See Schiller (1996) - Why Do People Dislike Inflation? for a more detailed discussion of people’s perception or misunderstanding of inflation. Clearly, people have strong opinions regarding inflation, placing them at least close to the quality of education, and the war on drugs (although, the veracity of the war on drugs is rather questionable, especially when we speak public opinion).
Historically, periods of deflation and inflation acted cyclical. The beginning of the 1920s and 1930s marked deflation periods of nearly minus fifteen per cent. In the last 50 years, inflation has become the norm. Inflation rates became a problem in the 70s when 10 to 15 per cent increases in the price level were hit per year combined with rising unemployment to form a phenomena called stagflation. In a relief, the 90s and on brought more stable inflation rates - closer to the common target rate of 3 per cent per annum.
Central bank policy has become stricter and more knowledgeable as well as chartered with clearer goals, likely causing inflation rates to be managed more accurately - when the economy is going in to a period where deflation is expected, the central bank will inject money (increasing the money supply) to lower the interest rate. Periods where high inflation rates are expected, Open Market Operations can be performed to reduce the available money supply, and encourage deflationary, or contractionary monetary policy.
Measuring inflation is tricky. Increases in real (inflation adjusted) GDP are a good thing, since they mark a real growth in the economy - increases in technology, well-being, production, efficiency, etc. The process of calculating “real” GDP, as opposed to nominal GDP is called deflating - a process of comparing the change in average price level of all goods and services in this year’s calculations, to that of the base year (currently the year 2000). The GDP deflator is the variable which interfaces between nominal and real GDP - the variable that represents the difference.
In reality however, GDP is not “deflated,” it’s counted twice - once as real GDP, using a base year’s prices and multiply them by the quantity of consumption of the same goods in the current year - then again as nominal GDP, using current year prices. This allows real GDP to be used to calculate the real growth of the economy, independent of prices1. Furthermore, the base year is a relevant problem here - technologies and products themselves change dramatically (the “composition of the bundle”) even over a short number of years - the closer to the base year you are for calculating real GDP, the more accurate it is and the less this factor effects well-being calculations.
An example of why real GDP and nominal GDP are very different measures is simple: if the nominal GDP of a country in 2000 was 10, and the nominal GDP in 2010 will be 20, they’ve experienced GDP growth of 100%. However, if inflation and the value of the dollar has changed negatively by 200% in the same period real productivity growth is in fact negative. Calculating based on real GDP in that period removes the problem (the real GDP in 2010, using a 2000 base year, would be equal to approximately the sum of (prices(2000) x quantity(2010)).
The GDP deflator, to some, counts as a metric of inflation. Obviously, if real GDP is increasing (that is, we’re producing more stuff), especially if real GDP per capita is increasing, our production is increasing too. If nominal GDP is increasing, that isn’t clear - perhaps the measurement units (dollars) are shrinking. The GDP deflator measures the change in the price of the entirety of production - while indexes such as CPI only measure the change in a single “basket” of goods. The CPI is, in fact, made up of a basket of about 700 goods that consumers consume annually - a good metric of rising prices, though not a fair one.
Increases in CPI don’t account for the substitution effect - that is, changes in what people actually do consume. While the basket is relatively constant (that is, it doesn’t adjust to demand, new products, or shifts in consumer perceptions), consumer demand is not - if prices of apples go up a lot, people will probably switch to consuming more oranges - in a way that increases utility. In this sense, CPI overestimates the negative effects of inflation on savings. It turns out this isn’t that important, in the sense that inflation does not effect most people’s flow - that is, their income - in a negative way, generally, wages above the minimum wage (at which point people are already making more than the market says they are worth) will be explicitly or implicitly linked to a real metric of inflation (not an estimate like CPI or the GDP deflator).
The GDP deflator indexes everything which GDP is comprised of - to frame this in general categories, that is consumption, investment, government spending, and net exports. This means that GDP is hardly indicative of that of the average household - at least, directly. The average household’s consumption in the short term is going to be more accurately represented by the CPI, though, the economy’s short-term spending and (since businesses and the government are effectively owned and controlled by households) long-term adjustments will be entirely understood through the GDP deflator2. If GDP is accurate - a number of questions are raised by macroeconomists about the efficiency of measuring inflation with the GDP deflator.
A number of other ways of estimating the effects of inflation are to look at indexed average or general wage rates for consumers. If the value of dollars is going down, employees are going to get paid more to hold the same value in their jobs. It’s argued, that to efficiency of the labour market, inflation allows people to get wage cuts without being offended - if your wage doesn’t get indexed directly to inflation, that is, it ends up being increased less than inflation, you’ve effectively had a pay cut. Some argue that this also has the opposite effect, wage increases are less expected, and individuals feel less reward when their wage is increased and they believe it’s just increasing to inflation - but Schiller’s analysis mentioned above in fact, suggests that people think they would be happier with higher wages even if prices went up the same amount (that is, they had no real wage increase). An interesting world indeed.
- This factor is more useful of course, if read in terms of per capita GDP, for increases in population do not mark increases in well-being, while they do increase production. [↩]
- That said, some think that household inflation effects are not at all measured by GDP deflator - these claim, oddly, that since the GDP deflator is based on all of GDP, then unless the average household is consuming the average of GDP the metric is going to be skewed. Of course, this misunderstands government and business - treating them as distinct entities; in fact, business is directly owned by households (through stocks, investments, loans, and direct ownership), and government spending is directly connected to households both in terms of how it benefits, and how it’s allocated. It’s arguable that democracy does not lend households the ability to hold government spending as “their own,” in that case, GDP deflator is a close estimate (ignoring government outlays) of what inflation is for a given household. It’s a complicated issue, clearly. It’s arguable that the “C” variable in GDP deflator, the consumer consumption portion is roughly equal to CPI. [↩]