**Nominal GDP**is GDP evaluated at current market prices. Therefore, nominal GDP will include all of the changes in market prices that have occurred during the current year due to

**or**

**inflation****deflation**.

**Inflation**is defined as a rise in the overall

**price**

**level**, and deflation is defined as a fall in the overall

**price**

**level**. In order to abstract from changes in the overall

**price**

**level**, another measure of GDP called

**real GDP**is often used. Real GDP is GDP evaluated at the

*market prices of some base year*. For example, if 1990 were chosen as the

**base year**, then real GDP for 1995 is calculated by taking the quantities of all goods and services purchased in 1995 and multiplying them by their 1990 prices.

**GDP deflator**. Using the statistics on real GDP and nominal GDP, one can calculate an implicit **index of the price level** for the year. This index is called the

**GDP deflator**and is given by the formula

**conversion factor** that transforms real GDP into nominal GDP. Note that in the base year, real GDP is by definition equal to nominal GDP so that the GDP deflator in the base year is always equal to 100.

**Calculating the rate of inflation or deflation**. Suppose that in the year following the base year, the GDP deflator is equal to 110. The

**percentage change**in the GDP deflator from the previous (base) year is obtained using the same formula used to calculate the growth

**rate**of GDP. This percentage change is found to be

** inflation rate** in the year following the base year was 10%. More generally, if the percentage change in the GDP deflator over some period is a

*positive X%*, then the

**over the same period is**

**rate**of**inflation***X%*. If the percentage change in the GDP deflator over some period is a

*negative X%*, then the

**over that period is**

**rate**of deflation*X%*.

**Consumer price index**. The GDP deflator is not the only index measure of the

**price**

**level**. Among the many other

**price**indices, the

**consumer**is the most frequently cited. The CPI differs from the GDP deflator in two important ways. First, the CPI measures only the change in the prices of a “basket” of goods consumed by a typical household. Second, the CPI uses base year quantities rather than current year quantities in calculating the

**price**index (CPI)**price**

**level**index value. The formula for the CPI is given as

**Construction of a price index**. As an example of a CPI index, assume for the sake of simplicity that the basket of goods consumed by a typical household consisted of just three goods: pizza, soda, and ice cream. The quantities consumed of each of these three goods in the base year are given in Table

The base year expenditure figures are found by multiplying the *base year quantities* by the *base* year prices. Similarly, the current year expenditure figures are found by multiplying the *base year quantities* by the *current* year prices. In order to calculate a CPI for this basket of three goods, one needs only the total base year and current year expenditures on all three goods. The CPI value for the *current year* may then be calculated as follows:

*base year* is always equal to 100. In this case,

* rate of inflation* in the

*current year*is 3.67%