# GDP Deflator

## What is GDP Deflator?

The GDP deflator is a measure of inflation defined over a specific period. It is the ratio of the value of goods and services produced in an economy in the current period to the value of these goods and services produced in the base year. The base year is the reference period starting from which price rise is calculated.

The GDP deflator is a price index which can be used to convert nominal GDP into real GDP. It is called a deflator as it is used to deflate the prices to the base year level. Generally, prices increase with time; thus, prices need to be deflated to achieve the real GDP.

Nominal GDP is the total value of all goods and services produced in a year. It is expressed in monetary terms. The price and quantity both belong to the current year. On the other hand, in real GDP, the quantity produced is from the current year while the prices are of the base year. Real GDP adjusts any changes in the prices while nominal GDP does not.

## Why is there a need for GDP deflator?

When the prices of goods and services increase over a year, then it is said that there has been inflation in prices. When the prices of goods and services become inflated, it gives a misleading picture of the production in the economy. This can give an inaccurate image of the income level in the economy.

Consider the situation where prices increase in the economy over a year, but the quantity produced in that year does not change. Going by the definition of nominal GDP, the value of goods and services (quantity * price) produced in that year would change. Thus, nominal GDP changes even when there is no change in the amount of goods and serviced produced.

Calculating the real GDP would show the actual picture. Real GDP includes prices of base year and quantity of current year. In the above example, when the quantity produced does not change, the real GDP remains the same. It does not give a bloated image of the production in the economy.

As nominal GDP rises without an actual rise in production, people expect their nominal income to increase as well. However, the real income in their hands remains the same. Therefore, to counterbalance inflation, an index is used so that the real price level in the economy can be realised.

## How is GDP deflator calculated?

The following formula gives the GDP Deflator:

Consider the hypothetical case where an economy only produces apples and oranges. The prices of both apples and oranges change over a year, from Year 1 to Year 2, and so does their production. The change in prices and quantities can be summarised in the following table:

Now for these prices and quantities, nominal GDP for Year 2 would be equal to the total value of goods and services in the economy. Nominal GDP in Year 2 is \$620.5 (= \$382.5 + \$238).

Now taking Year 1 as the base year, real GDP in Year 2 can be arrived at by multiplying the quantity in Year 2 with the prices in Year 1. Therefore, real GDP in Year 2 is \$705 {= (\$2.5 * 170) + (\$2 * 140)}.

Therefore, by the formula of GDP deflator, we get the following for Year 2:

GDP Deflator = (620.5 / 705) * 100 = 88.01

A GDP deflator of 88.01% means that the prices have fallen by 12% in Year 2 as compared to the base year, which, in this case, is Year 1. When the GDP deflator exceeds 100% it means that prices have increased.

The prices of both apples and oranges have fallen in Year 2. However, the nominal GDP has increased in the economy in Year 2, from \$575 to \$620.5. As prices decline, the quantity demanded of both the goods increases as stated by the Law of Demand. The effect of decreased prices is overshadowed by the impact of increased quantities, which explains why nominal GDP increased overall, even when the prices dropped.

## What is the difference between GDP deflator and other measures of inflation?

There are indexes other than the GDP deflator that can be used to adjust for inflation. One example of such an index is the Consumer Price Index. However, there is an underlying difference between assumptions of the two indexes. Consumer Price Index assumes that the quantity of goods produced in the economy remains the same, while GDP deflator does not include any such assumption.

In this sense, GDP deflator is a better measure of price inflation. It accounts for changes in the basket of goods produced as well as the changes in the prices of these goods. CPI fails to include the entire production in the economy.

Another commonly used index is the Wage Price Index (WPI). Like CPI, WPI also does not consider any changes in the basket of consumption. Also, WPI does not include the services sector in it. Because of these reasons, GDP deflator is preferred over WPI and CPI. However, CPI and WPI are published monthly because the GDP deflator can only be calculated with a lag. Therefore, CPI and WPI are used to track monthly changes in inflation.

What is Keynesian economics? Keynesian economics is the economic theory that states demand is the driver of economic growth. This economic theory also states that fiscal aid helps recover an economy from a recession. Certain Keynesian economic principles stand in stark contrast to the Classical theory of economics. The theory was given by John Maynard Keynes in the 1930s and published in Keynes’ “General Theory of Employment, Interest and Money” in 1936. The Keynesian theory stated that government spending was an essential factor in increasing demand and maintaining full employment. What are the theories under Keynesian economics? Aggregate demand is affected by a host of factors: Aggregate demand is affected by various factors public and private factors. Monetary and fiscal policy both affect the level of aggregate demand in the economy. Any decision taken by the monetary authority or the government greatly affects the economy’s level of demand. Say’s Law proposes that supply generates its own demand. However, Keynesian economics suggests that demand is the driver of supply and overall growth in the economy. Sticky Wages: According to the theory of sticky wages, employers would prefer laying off workers over decreasing the existing workers’ wages. This happens because even in the absence of labour unions, workers would still resist wages cuts. Even if the employers were to reduce wages, it would lead to economic depression as demand would fall and people would become more cautious about their spending. Keynes advocated that the labour markers do not function independently from the savings market. Therefore, prices and wages respond slowly to changes in supply and demand. Liquidity Trap: Liquidity trap refers to an economic scenario where there is a contraction in the economy despite very low interest rates. This contrasts with the relationship between interest rates and investment given in Classical economics. How is Keynesian economics different from Classical economics? Classical economics states that the economy self-regulates in case of a disequilibrium. Any deviations from the market equilibrium would be adjusted on its own without any government regulation. However, Keynesian economics propagates that government intervention must maintain equilibrium or come out of an economic downturn. Keynesian economics highlights the importance of monetary and fiscal policy, while Classical economics does not mention any government intervention. Another crucial difference is that Classical economics suggests that governments should always incur less debt, while Keynesian economics advises that governments should practice deficit financing during a recession. Classical economics states that government spending can be harmful as it leads to crowding out of the private investment. However, it has been later established that this happens when the economy is not in a recession. Government borrowing competes with private investment leading to higher interest rates. Thus, Keynesian economics is of the view that deficit spending during a recession does not crowd out private investment. What are the policy measures advocated by Keynesian economics? According to Keynes, adopting a countercyclical approach can help economies stabilise. This means that governments must move in a direction opposite to the business cycles. The theory also states that governments should recover from economic downturns in the short run itself, instead of waiting for the economy to recover over time. Keynes wrote the famous line, “In the long run, we are all dead”. The short run knowledge of the economy would be far better than the long run prediction made by any government. Thus, it makes sense for governments to focus on short run policies and maintain short run equilibrium. Keynes’ multiplier effect states that government spending would increase the GDP by a greater amount than the increase in government spending. This multiplier effect established a reason for governments to go for fiscal support when the economy requires it. What have been the criticisms of Keynesian economics? The initial stages of Keynesian economics propagated that monetary policy was ineffective and did not play any role in boosting economic growth. However, the positive effects of monetary policy are well established and have been integrated into the new Keynesian framework. Another criticism is that the advantage of the fiscal benefits to the GDP cannot be measured. Thus, it becomes difficult to fine-tune the fiscal policy to suit the economic scenario better. Also, the Keynesian belief of increased spending leading to economic growth may lead to the government investing in projects with a vested interest. It could also lead to increased corruption in the economy. The theory of rational expectations suggests that people understand that tax cuts are only temporary. Thus, they prefer to save up the income left behind to pay for future increases in taxes. This is the Ricardian Equivalence theory. Thus, fiscal policy may be rendered ineffective due to this. Supply-side economics has also shown contrast to Keynesian beliefs. During the stagflation in the 1970s, the Phillips curve failed, bringing out the importance of supply-side economics.

What is meant by Balance of Payments or BOP? Balance of Payments refers to the record of transactions maintained by a country with the rest of the world. It is a detailed list of international transactions that a country has with its trading partners. These transactions can be made by the residents, domestic businesses or by the government. In an ideal situation, the sum of all the elements of BOP should be zero. However, this is rarely witnessed as most countries do not have the exact same amount of inflow as that of outflow. The inflow and outflow from the rest of the world, can be with respect to goods, services, assets, investments, etc. Notably, a deflection from the ideal zero BOP state may not always be harmful. A surplus (positive BOP) might indicate a strong economy as it means exports are greater than imports. While, a deficit (negative BOP) might point to an increased debt on the home country. The Balance of Payments is highly reflective of the economic strength of a country. Most of the impacts of BOP are indirectly observed on various macroeconomic indicators. What are the Components of BOP? BOP comprises of two broad components, namely, Current Account and Capital Account. Sometimes the Capital Account is referred to as the Financial Account, along with a separate capital account. The Financial Account includes transactions in financial instruments and central bank reserves. While the capital account includes transactions in capital assets. A balance in inflow and outflow of all these accounts makes for a BOP equal to 0. CURRENT ACCOUNT: In technical terms, Current Account is the sum of Balance of Trade, Factor Income (net income from foreign investments) and unilateral transfers (net gifts and grants received). Put simply, current account records the transactions done in goods and services, investments and the net transfer payments or unilateral payments. Exports are maintained as credits, while imports are maintained as debits in the balance of payments. A positive current account balance means that the domestic country is a net lender, while a negative current account balance indicates that the home country is a net debtor. According to the double-entry accounting method, any entry on the export side would be adjusted with an appropriate entry on the import side. For example, for a good exported by the home country to a foreign country, the corresponding import transaction would be the inflow of foreign currency received in exchange for the good exported. CAPITAL ACCOUNT: The capital account involves all transactions relating to international asset It involves transactions made in the reserve account as well as loan payments and investment made across nations. These loans, however, do not include the future stream of interest or dividend payments as they are a part of current account. This is so because they form a part of nation’s spending or income, depending on the type of flow. A capital account is said to be in deficit when a country purchases more assets than the assets it sells to the rest of the world. An increase in assets is followed by a corresponding decrease in cash and vice versa. In some countries, the capital account is known as the financial account and has separate component called the capital account. This capital account records the transactions that do not affect the income, production or savings like international transfer of trademarks and rights, etc. What do BOP deficit and surplus mean for the home country? In layman’s language, BOP tells us whether the country is earning enough to meet its expenditure. If there is a deficit, then it can point towards the country’s growing expenses which are not sufficed by the income generated. Thus, there is a need to generate debt in order to fund the current requirements. Many a times the need to repay current debt gives rise to more debt. Therefore, an endless cycle of financing previous debt with current period loans takes place. The credit received from the rest of the world is generated either by taking a loan, which adds as a liability in the accounts or by selling off the assets currently possessed by the country. These assets can be natural resources, land, commodities, etc. A surplus on the other hand means that a country is exporting more than it is importing in all its existing BOP accounts. This can be a positive sign in most instances as it points towards stronger economic movements. A surplus can encourage the home country to invest in production of goods and services and in turn promote GDP growth. However, an export-driven growth in the long run could point to lack of sufficient demand in the home country. In such a case, the government should boost consumer spending in home country in order to become more self- reliant.   What are the factors affecting BOP? BOP depends on various factors. These include: The domestic exchange rate: Exchange rate is a measure of foreign currency with respect to the domestic currency. Governments can revalue or devalue the exchange rate with the help of appropriate policies. This affects the BOP by making exports cheaper as the exchange rate falls and making imports cheaper when the exchange rate rises. The spending capacity of domestic consumers: As businesses and households are left with greater disposable income, they can spend more on imports and this can affect the BOP. Price competitiveness offered by domestic goods: For a country that is going through higher rates of inflation than its trading partner, the goods and services offered by it would be relatively more expensive. Thus, the country becomes less competitive in terms of price competitiveness. The country with lower inflation would thus have cheaper exports. In such a case, domestic consumers would prefer foreign goods and services causing increased imports and eventually a BOP deficit. Domestic policies: Trade based taxes and tariffs are a huge influencer on the BOP. Policies boosting exports are always beneficial to a country. It is important to pay attention to imports by imposing restrictions using tariffs or quotas. Apart from trade centric policies, domestic policies aimed at economic growth may cause changes in BOP. For instance, increased interest rates can promote FDI in the home country, which would affect the Current Account in BOP.

Bear market is a scenario when the prices of securities are only moving in a downtrend for a prolonged period. Pessimism and fear across the board grips the market which leads to continuous selling pressure from the market participants, leading to downtrend. Apart from stock market, Bearish trends can also be present in other markets such as currency, commodity or bond market.   What Do We Mean by Stock Market? The stock market or financial markets in general, which includes stocks, bonds, commodities etc,  is a virtual marketplace for buyers and sellers willing to make a deal. Every party has his/her own analysis/view or opinion about the underlying security regarding its worth with respect to what it may be worth in the future.   What Drives Stock Price Movement? As the constant buying and selling of securities take place, the prices also fluctuate with respect to each of these transactions. This price fluctuation happens in either of the two directions, up or down based on the demand and supply equation.   In other words, where the price move would depend on whether the demand is higher than supply or is it the other way. If the demand for the security outstrips the supply, i.e. more no. of buyers is willing to buy than the no. of sellers who are willing to sell at that point of time, then the price tends to move up.   Similarly, if the no. of sellers is outnumbering the no. of buyers for the security at the same time, then the price tends to move down. All the price movement works on the universal law of demand and supply.   So, what is a Bear Market? As the prices are ever-changing, often they are not random and tend to move in a particular direction. Sometimes, due to excessive pessimism and fear among the market participants, the supply of securities gets overwhelmingly high, which leads to a fall in the prices for a prolonged period. This continuous fall in the price for a long time, often a few months/ years is referred to as a Bear market.    The secular bear market, which is a part of the stock market cycle, is often witnessed after a period of distribution which succeeds a strong bull market.   Although there is no estimate as to how long a bear market could continue, history tells us that often it lasts for a lesser time than a bull market but can be more erratic and fast during its fall.   What are the Triggers for a bear market? The major bear market which generally comes once in a decade can last up to a few years, although for   individual stocks it may last up to a few months respective bear market because individual stock’s fundamentals may change relatively more quickly than the broader economy.   This extended period of constant supply is not random and need a few reasons to sustain. These reasons are the major fundamental changes taking place behind the scenes. A few of these could be;   Weak corporate earnings Excessive inflation Downgrades by rating agencies Slowing GDP growth Incompetent top management (for Individual stocks)   How is a Bear market different from a normal correction? It is to be noted that the bear markets fall is completely different from the fall witnessed during an up-trending market. The market never moves in a straight line but rather in a wave-like pattern. This simply means even while moving up; it takes corrections or dips in the opposite direction and small rallies on the upside while trending down.   Therefore, a broader direction of the trend needs to be considered while identifying the bull or a bear market.     How to Quantitatively measure a bear market? Sometimes it gets difficult to measure as to when a bear market has started or ended as the price is always moving and fluctuating. But there are some quantitative measures available that can do the job in an objective way.     One of the measures which are generally used for the broader market is to look at the retracement level. A retracement is a move which is opposite to the bigger trend. As discussed above, markets take correction while moving up and shows rallies while going down. These dips in an uptrend and rallies in a downtrend are the retracement move.   A 20% retracement from a significant high point, preferably after the bull market is considered as the start of a bear market. Similarly, after the lowest point in a bear market, if the market retraces up by 20%, the bear market is considered to be over.   Another measure is to use a long-term moving average, like a 200-day. This method is very popular among individual stocks. A 200-day moving average is plotted on the stock’s price chart, and its interpretation is quite simple. If the stock is trading above the long-term moving average, then it is considered to be in a bull market and below the moving average is a bear market zone.     Which Strategies to be used in a bear market? When the market or a stock keeps on falling for a prolonged period, then a few strategies could come in handy to survive bear market or even mark decent profits like;   Selling the rallies As stated earlier, even in a downtrend, the market moves in a wave and shows some small rallies on the upside which ultimately get fizzle out, and the downtrend continues. These rallies are an ideal point for the short-selling as one can get a better price.   Selling after the break of support. Going short just after the support level gets breached is another approach to make money in a bear market. Although selling the support would yield a lower price for selling but if the market is in a true bear run, then expect a lot of support levels to be taken out throughout the downtrend.   Look for base formation to enter long There is something for the long-term investors also. For an investor, a lower price is always a better price, and a bear market offers tons of opportunities to buy stocks dirt cheap. But the question is when to enter. One way is to look for a consolidation phase after a severe fall, also known as the accumulation zone. It is the area where a lot of buyers come in to buy stocks at a low price, hence halts the prices to fall further. These consolidation zones are a good place to accumulate stocks, instead of trying to catch a falling knife.