Implicit Price Deflator (Encyclopedia of Business)
The implicit price deflator is an index that is used to gauge the extent of price level changes or inflation in the economy. This index is essentially one of three different methods by which inflation in the economy is measured. Knowledge of two concepts, the notions of inflation and price index, is crucial to understanding the implicit price deflator.
INFLATION AND DEFLATION
Inflation is understood to be an increase in price level. It is actually defined as the rate of change in the price level. Thus, an inflation rate of five percent per annum means that the price level is increasing at the rate of five percent. However, inflation need not always be positive. It may be a negative number, in which instance the price level would be declining. Negative inflation rates (deflation) are very uncommon. Most economies face positive rates of inflation year after year.
PRICE INDEX AND THE MEASUREMENT OF THE INFLATION RATE
The inflation rate is derived by calculating the rate of change in a price index. A price index, in turn, measures the level of prices of goods and services at any point of time. The number of items included in a price index varies depending on the objective of the index. Usually three kinds of price indices are periodically reported by government sources. The first index is called the consumer price index (CPI). This index measures the average retail prices paid by consumers for goods and services. There are approximately 400 items included in this index including several thousand products. These items are selected on the basis of their inclusion in the household budget of a consumer. Each of the 400 prices is assigned a weight based on the importance of the item in the household budget. As a result, the consumer price index reflects the changes in the cost of living of a typical household (consumer). The CPI is considered the most relevant inflation measure from the point of view of the consumers, as it measures the prices of goods and services that are part of their budgets. However, the consumer price index will not measure the changes in the cost of living of every consumer precisely due to the differences in consumption patterns.
A second price index used to measure the inflation rate is called the producer price index (PPI). It is a much broader measure than the consumer price index, in that it measures the wholesale prices of approximately 3,000 items. The items included in this index are those that are typically used by producers (manufacturers and businesses) and thus contain many raw materials and semi-finished goods. A change in the producer price index reflects a change in the cost of production, as encountered by producers. Since producers may pass on part or all of the increase in the cost of production to consumers, movements in producer price index indicate future movements in the consumer price index. The producer price index can thus forewarn consumers of coming increases in the cost of living.
The implicit price deflator is the third measure of inflation. This index measures the prices of all goods and services included in the calculation of the current output of goods and services in the economy, known as gross domestic product (GDP). It is the broadest measure of the price level. This index includes prices of fighter bombers purchased by the U.S. Department of Defense as well as paper clips used in common offices. Thus, the implicit price deflator is a measure of the overall or aggregate price level for the economy. Movement in the implicit GDP price deflator captures the inflationary tendency of the overall economy.
CALCULATIONS OF THE IMPLICIT PRICE DEFLATOR AND THE INFLATION RATE
Calculation of the consumer price index (CPI) and producer price index (PPI) is directndexes are calculated from price data on the items included. The implicit price deflator, on the other hand, is inferred indirectly from the estimates of gross domestic product in nominal terms (in current dollars) and in real terms (when the nominal value of gross domestic product is adjusted for inflation by re-evaluating the GDP in prices that prevailed during a chosen base year).
Currently, 1992 is being used as the base year to calculate the real value of gross domestic product in the United States. Thus, the 1998 U.S. output of goods and services is first evaluated at prices prevailing in 1998. Once this is done, 1998 output of goods and services is also evaluated at prices that prevailed in 1992 (thus, the terms gross domestic product in 1992 dollars or constant dollars). One can easily see how the ratio of gross domestic product in 1998 prices and gross domestic product in 1992 prices would yield a measure of the extent of the rise in price level between 1992 and 1998. According to the federal government statistics, this ratio is estimated at 1.1307, or 113.07 when multiplied by 100 (as is customarily done to determine the extent of price increase more conveniently). The value of implicit price deflator of 113.07 implies that the price level increased by 13.07 percent over the 1992-1998 period (note that the base year, currently 1992, value of implicit price deflator is equal to 100).
This method of expressing nominal or current gross domestic product into its value in 1992 prices is routinely done every year (of course, sometimes the base year itself, may be changed to a later year to keep the data series closer to the current period). Thus, we have 1997, 1996, 1995 (and so on) gross domestic products expressed in 1992 prices. This helps to calculate the inflation rate between subsequent years. For example, the implicit price deflator stood at 112.08 at the end of 1997. Given that the deflator was at 113.07 at the end of 1998, we arrive at the annual inflation rate of roughly 0.88 percent during 1998 (1998 inflation rate = [(113.07 - 112.08) / 112.08] * 100).
Since the implicit price deflator is derived from the nominal and real values of the gross domestic product (GDP), it is also called implicit GDP price deflator. One should also notice that the term deflator is not used in consumer and producer price indexes. This is because, if one knows the implicit price deflator for 1998, and the 1998 gross domestic product in current prices, one could arrive at the gross domestic product in 1992 prices by deflating the 1998 gross domestic product in current prices by the deflator for 1998 (expressed in plain ratio form, rather than the one multiplied by 100). Despite the use of term deflator, one should not lose sight of the fact the implicit price deflator is essentially a price index.
SEE ALSO: Index/Indexes; Inflation
[Anandi P. Sahu, Ph.D.]