What Exactly Does the GDP Deflator Measure?

As Menzie explained on Monday, it isn't inflation. Since there still seems to be some controversy about this issue (e.g., Rich Karlgaard, Instapundit, and 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.

Comments

[CrossProfit:]

Cute!
The follow up is that because it now costs $630, in order to maintain a certain standard of coconut living, coconuts will now have to sell for $1.05. This means that next year we are at $655 or consume less coconuts and/or oil.
Though imported inflation doesn't show up in GDP immediately it does have a knock on effect and is heavily correlated with trade imbalances that in turn feeds upon itself, usually manifested through currency devaluation. The actual devaluation tends to mitigate the effect by reducing consumption.
However, you are correct in stating that the deflator tends to give a false impression resulting in mistrust of official figures.
The figures are not the real issue, the implied interpretation of them is. If this is what you meant to say, then we are in agreement.

CrossProfit

2008 Aug 06 05:18 AM

[Umm, yeah:]

You left out the hedonics adjustment because the coconuts sold this year are 1% better than last year's and therefore, there's no inflation at all...

2008 Aug 06 08:39 AM

[Badgolfer:]

Thanks for the simple explanation.I always wondered if this stat was worthless.You've confirmed it

2008 Aug 06 09:21 AM

[Jason Rines...:]

That illustration is a keeper to educate Joe Six Pack.

2008 Aug 06 11:09 AM