Underestimation of Inflation by GDP Deflator!

The GDP deflator underestimates true inflation.

The reason is that the GDP deflator reflects the prices of all goods and services produced domestically consumers, whereas the CPI reflects the prices of all goods and services bought by domestic consumer.

For example, suppose the price of an airplane produced by an Indian company which is sold to the Indian Air Force rises.

Although the plane is a part of GDP it is not the part of the basket of goods and services purchased by an Indian consumer. Thus, the price increase shows up in the GDP deflator, but not in the CPI.

Now suppose the Toyota raises the price of its cars. Since Toyota cars are made in the Japan they are not a part of India’s GDP. But Indian consumers buy Toyotas and so the car is part of Indian consumers’ basket of goods. Hence a price increase of an imported consumer good, such as Toyota, gets reflected in the CPI, but not in the GDP deflator.

This first difference between the CPI and the GDP deflator is particularly important when the price of oil rises. Although India produces some oil much of the oil consumed in India is imported from the Middle East. As a result, oil and oil products, such as petrol and diesel comprise a much larger share of consumer spending than they do of GDP.

When the price of oil rises the CPI rises much more than does the GDP deflator. Thus the GDP deflator underestimates true inflation.

Another difference between the GDP deflator and CPI concerns how various prices are weighted to yield a single number for the overall level of prices. The CPI compares the price of a fixed basket of goods and services to the price of the basket in the base year. By contrast the GDP deflator compares the price of currently produced goods and services to the price of the same goods and services in the base year.

Thus, the group of goods and services used to prepare the GDP deflator automatically changes from year to year. This difference is not important if all prices rise or fall at the same rate. But if the prices of different goods and services are not changing proportionately, the way we weigh the various prices matters for the overall inflation rate.

The GDP deflator and CPI differ from time to time. For example, at times when the price of imported oil rises sharply the CPI is likely to rise faster than the GDP deflator.

So, the difference between the GDP deflator and the CPI is not very large. Both indicate more or less the same thing about how fast prices are rising. In fact, over long periods of time, they produce more or less the same measure of inflation.

Need for Chain Weighting:

When relative prices of different goods keep on changing quite rapidly we get a wrong estimate of real GDP growth if we use prices of a fixed year.

This bias can be corrected by using a procedure called chain weighting. Instead of keeping the relative weights on each good fixed (say, by using weights for a given year, such as 2004), the weights of the different goods and services can be changed each year to reflect the changes in spending patterns in the economy.

The calculation of chain weights involves linking the output or price series together by multiplying the growth rates from one period to another. A simple example for an economy which produces only one good such as bread will show how this procedure works. Let us suppose the value of bread was Rs. 300 in 2004.

Furthermore, suppose that the quantity of bread increased by 1% from 2004 to 2005 and by 2% from 2005 to 2006. Then the value of real GDP (in chained 2004 rupees) would be Rs. 300 in 2004, Rs. 300 x 1.01 = Rs. 303 in 2005 and Rs. 303 x 1.02 = Rs. 309.06 in 2006.

With many different goods and services, we would add together the growth rates of different components of oranges, apples, onions, potatoes, haircuts, health care and so on and weight the growth rates by the expenditure or output shares of the different goods.

In short, nominal GDP (PQ) is the money value of all final goods and services produced in India in an accounting year, where the values are expressed in terms of the market prices in each year. Real GDP (Q) removes the effects of price changes from nominal GDP and calculates GDP in terms of the quantities of goods and services.

The GDP price index (P) is the’ ‘price of GDP ‘ and is determined by using the following formula:

To correct for rapidly changing relative prices, national income accountants use chain weights to construct real GDP and price indices.