Use the formula for the GDP deflator to explain how it is affected by an increase in prices in the economy. If the value of the deflator equals 100, what does that tell you about that year with respect to the base year?
What will be an ideal response?
The formula for the GDP deflator is given by:
The GDP deflator = × 100
From this formula we can see that if prices are rising in the economy but production remains constant, nominal GDP will go up but real GDP will remain the same, so the deflator should rise. If prices rise more rapidly than production in the economy, then nominal GDP will rise relative to real GDP and the value of the GDP deflator will rise. It is in this way the deflator can help economists track changes in prices in the economy over time.
If the value of the deflator is 100 in a particular year, that year must be the base year or nominal GDP and real GDP are exactly the same.
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