Submitted by Edward Harrison of the site Credit Writedowns
Now that everyone is talking about green shoots and the potential for economic recovery, I thought I would run through the statistics of U.S. GDP with you. The reason I am bringing this up is that there is a lot of confusion about what recovery means and positive GDP growth mean. So, I am going to spell it out in a bit more detail here. I will start with recession, which will lead into recovery – the thing we are all interested in right now. Afterward, I will briefly sketch out what GDP is and throw some numbers up to illustrate a few points before wrapping up with a conclusion.
What is a Recession
In the United States, the official dates for a recession are determined by the National Bureau of Economic Research (NBER). Wikipedia has a useful definition of the organization:
The NBER was founded in 1920. Its first staff economist and Director of Research was Wesley Mitchell. Simon Kuznets was working at the NBER when the U.S. government asked him to help organize a system of national accounts in 1930, which was the beginning of the official measurement of GDP and other related indices of economic activity. Due to its work on national accounts and business cycles, the NBER is well-known for providing start and end dates for recessions in the United States.
The NBER is the largest economics research organization in the United States[2]. Sixteen of the thirty-one American winners of the Nobel Prize in Economics have been NBER associates, as well as three of the past Chairmen of the Council of Economic Advisers, including the former NBER president,Martin Feldstein. NBER research is published by the University of Chicago Press.
Now, the Business Cycle Dating Committee at the NBER is the group that decides when a recession has occurred, usually with a significant lag (the recession starting in December 2007 wasn’t called until December 2008). As far as I know, the Dating Committee is really a virtual group of economists which don’t actually meet, but rather discuss things via e-mail, telephone, what have you in an ad hoc and informal fashion before arriving at the critical moment when they must come together and date the business cycle. On their website there is a page called, “Business Cycle Expansions and Contractions” which has a good note in the footer about what recessions actually are. It reads:
The NBER does not define a recession in terms of two consecutive quarters of decline in real GDP. Rather, a recession is a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales. For more information, see the latest announcement from the NBER’s Business Cycle Dating Committee, dated 12/01/08.
I hope that clears up the fallacy of the two quarters’ decline in real GDP, a shorthand that has developed but is inaccurate. SO, to sum it up, in the U.S., the NBER has the final say regarding determining business cycles. They are looking at weakness in four key areas – income, employment, production and sales in order to date a recession.
Recovery
When it comes to recovery, the NBER are using the exact same methodology in reverse. Their statement regarding the last recovery in 2001 is telling regarding how this process works.
The committee’s goal is to determine the dates of peaks and troughs as definitively as possible. The committee is careful to avoid premature judgments. The initial announcements of many of the major indicators of economic activity are preliminary and subject to substantial revisions, so it is not possible to identify the month of a peak or trough rapidly. The main reason that the committee’s decision in this episode was particularly difficult was the divergent behavior of employment. The committee felt that it was important to wait until real GDP was substantially above its pre-recession peak before determining that a trough had occurred, and to study the NBER’s past practices carefully to ensure that its decision in this episode was consistent with the dating of earlier turning points.
What is interesting to note is that at least one member of the Dating Committee, Robert Gordon, a Professor of Economics at Northwestern University, is showing his cards already. Last week, I posted an article he wrote suggesting that the recession is about to end (See my post “Jobless claims may signal the end is near”). Apparently, he thinks recovery may be coming.
You should notice that the NBER uses the term ‘peak’ to describe the onset of a recession and ‘trough’ to describe the onset of recovery. So, really recession is the phase after the business cycle has peaked. It ends and we get a recovery when the business cycle has troughed. That’s the terminology.
GDP
This terminology makes a good entree into GDP and what it is. Going back to Wikipedia, GDP is described as follows:
The gross domestic product (GDP) or gross domestic income (GDI), a basic measure of an economy’s economic performance, is the market value of all final goods and services produced within the borders of a nation in a year. [1] GDP can be defined in three ways, all of which are conceptually identical. First, it is equal to the total expenditures for all final goods and services produced within the country in a stipulated period of time (usually a 365-day year). Second, it is equal to the sum of the value added at every stage of production (the intermediate stages) by all the industries within a country, plus taxes less subsidies on products, in the period. Third, it is equal to the sum of the income generated by production in the country in the period—that is,compensation of employees, taxes on production and imports less subsidies, and gross operating surplus (or profits).[2] [3]
What you should notice in the definition is that GDP is a measure of “goods and services produced” not sold. And this is something I will get back to later. What the statisticians are trying to do is value everything that is produced in the United States domestically and sum it up as an aggregate number. That is all GDP really is.
GDP as reported
From my view point point, the interesting bit about GDP is NOT inflation (i.e. real vs. nominal GDP), but rather the fact that the number which is reported is a first derivative. It is the change in GDP which is reported, not the actual number. And, this is significant because generally a business cycle troughs when the change in GDP goes from being negative for a significant period to being positive for a significant period. Equally, a business cycle peak (read recession) occurs when the change in GDP goes from being positive for a significant period to being negative for a significant period. So, it is the change in GDP that everyone cares about. But, reporting the change brings in a few statistical anomalies that are important.
Negative numbers are bigger than positive numbers
The first problem with measuring a first derivative is that negative percentage changes have statistically greater effect than positive percentage changes. Let me give you an example. Say GDP starts at 100 and it drops 20% to 80, if it rises 20%, you get back to 96, not 100. The 20% down move is the equivalent of a 25% up move. So, in a country like Latvia, where GDP is down 20% annualized, you need an even large push to the upside of 25% to get back to even. Net, net, this means recovery has to be either stronger or longer than the recession to get back to the pre-recession level of production.
Subtracting less negative means positive
Thinking about production as opposed to sales again, you have to look at inventories. The NBER is not fooled by inventory builds because they look at both industrial production and retail sales. But, since GDP is a pure production statistic, inventory builds distort the picture. For example, say your economy produces $980 worth of stuff one quarter that gets sold. But it also sells a lot of stuff, $20 worth, out of inventory. If next quarter, you need to sell just as much stuff ($1000), guess what, GDP growth goes up automatically (Remember, we are not talking about GDP, but GDP growth). The inventory purge means you are producing less to meet demand than you would otherwise need to. So, when comparing one quarter to the next, unless you purge just as much stuff or unless demand goes down, you need to produce more. Therefore, you get an automatic uptick in GDP growth.
in my post “GDP: 4th quarter 2008 was worse,” I said this about Q1 GDP:
clearly the consensus was much too bullish as I predicted. And the main culprit was inventories, which were purged at a $136.8 billion annual rate. That is enormous. In fact, Q1 2009 saw the largest inventory purge ever. As a percent of GDP, you have to go back to Q4 1982 to get a more liquidationist reading.
Now, if you think about this in the context of what I just presented, it makes it pretty clear that you don’t need to build inventories to get an uptick in GDP growth. All you need to do is purge fewer inventories. Subtracting a less negative number is the same as adding a positive number. And I doubt we will be purging an annualized $136.8 billion in inventories going forward.
Recovery does not mean recovery
My final thought on the statistics here has to do with starting from a lower base. Before the Great Depression in 1929, the U.S. had nominal GDP of $103.6 billion. By 1933, this had dropped to $56.4 billion due to deflation and a decrease in production. Over the next four year, GDP growth soared. It was 17.0% in 1934,11.1% in 1935, 14.3% in 1936 and 9.7% in 1937. That’s some serious growth, right? Well, GDP was only $91.9 billion in 1937, a full 11.3% lower than it had been 8 years earlier. In fact, it wasn’t until 1941 that we attained the nominal production output of 1929.
What this should illustrate is that working from a lower base makes an increase in GDP comparatively easier than when working from a higher base. Yes, it was a powerful recovery, but it did NOT get the United States back to the same productive level for many years. In that sense, recovery does not mean recovery immediately.
Thoughts
Having run through this, I have a few thoughts.
- The massive inventory purge we just witnessed is more significant than people realize. The numbers I ran through should help demonstrate this. Would it be wild to think Q3 could see a positive GDP growth number? Perhaps, especially with an idled auto sector. Nevertheless, we should think outside the box here.
- The same logic for inventories (i.e. subtracting a less negative number is the same as adding a positive) is at play with imports – but in the opposite direction. As recession took hold, U.S. trade shrank, reducing both imports and exports. But, since the U.S. is a debtor nation, the shrinkage in imports has been much larger than the shrinkage in exports (why else do you think we saw horrific declines in exports from Asia in January and February?). That has been a plus for statistical GDP growth. If we do get a recovery, unless people save much more, this same dynamic in reverse will be a drag on GDP growth.
- It should be pretty clear now that just because we get a recovery does not mean the United States is going back to where it was. After all, the financial services sector is still fairly sick and it comprised an outsized percentage of GDP. So, unless Geithner, Summers and Bernanke can reflate the sector as they seem to be trying to do, the U.S. is going to need to make up the slack from somewhere else. This suggests that the recovery will be weak.
So, most of this suggests an early but weak recovery. That’s pretty much my baseline view too. I would appreciate your thoughts on this as well.
Sources
NBER – Wikipedia
Business Cycle Expansions and Contractions – NBER website
July 2003 announcement of business cycle trough – NBER website
Determination of the December 2007 Peak in Economic Activity – NBER website
26 comments
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Hello Edward,
Excellent post. I will be discussing the recovery at length over the weekend.
I tend to agree with you that inventories have been slashed so much that Q3 growth is a shoe-in.
Importantly, inventories in housing are down cconsiderably in the U.S. and in some markets like California, housing prices have bottomed out.
The key is the housing market and the stock market. if they stabilize, we will avoid deflation and muddle our way through.
This will be another jobless recovery and in the short-run, unemployment will climb as more jobs are shed.
But all those economists calling for the savings rate to soar to 15% don’t have a clue about macroeconomics. if stocks keep grinding up and home prices stabilize, savings rate will increase but not soar to unprecedented levels (you need a depression for that).
All the indicators I look at suggest we are bottoming out. I will write about this over the weekend.
Also, one more thing a good economist reminded me of: the U.S. is not Japana. the demographics are very different which means it can avoid a protracted period of deflation.
cheers,
Leo
Thanks for the comments, Leo. I am looking forward to what you have to say on this issue at the weekend.
Make sure you give a read on how you see housing shaping up.
For me, the big wild card is Commercial Real Estate. Other than that, the recovery play seems to be taking hold (without the necessary deleveraging or purging of excess, I should add).
What always disturbs me about the GDP number is how increases in debt are ignored in the computation. Now granted it measures goods produced, but when you see a higher GDP number you tend to believe the economy is doing better. However, this is really a false sign. If the GDP number is increasing due to debt increases this is unsustainable and really gives me a sense of an unreal number.
For instance the US's GDP increased from somewhere in the $11 trillion range in 2001 to $14 trillion in 2007 but the increase in debt of the country accounted for all of this increase and really lead to the current problems. The GDP increase was unreal and unsupportable; however, the government uses this as a base to measure a number of disbursements such as military spending.
Personally, I believe the increase in debt should be subtracted from the GDP number to give us a sense of true sustainable GDP. Otherwise, you are doing a similar thing as only looking at the P&L statement of a company and not looking at the screwed up balance sheet.
I agree with Ishmael. GDP is swollen too much by debt.
There should be separation between GDP fuelled by debt which funds consumables and GDP fuelled by debt for production. Basically GDP should be reduced by the former quantity.
I have a lot of time for Shadow Govt Stats http://www.shadowstats.com/alternate_data
It can be seen that GDP has been negative almost every year for this entire decade!
Excellent point about negative percentages exceeding positive ones. Overlooked by most media when reporting GDP changes.
WINTERMUTE: “There should be separation between GDP fuelled by debt which funds consumables and GDP fuelled by debt for production.”
What’s the difference between a “consumable” and “production”? Why are you implying production is better?
Are you saying that debt used to finance car production is somehow better? GDP contributed by, say, GM is better than Apple?
Are you saying someone who finances excessive production (say China right now in my opinion; or say USA in 1930’s) is somehow better than someone who finances consumption (say USA now; or Europe in 1930’s)?
Early and weak, but then failure IMO. If credit is released (doubtful), re-employment is strong (doubtful) and the consumer comes back full strength (doubtful) and we keep inflation in check (doubtful) we’ll be just fine. My biggest concern is the debt load and taxes to pay for it. We’re robbing Peter (people) to help Paul (banks) and Peter won’t have any geedus left in a year or two.
The economy was saved by the government. We’ve borrowed our way back to growth! Yea!
Only problem is that “growth” for the past thirty years has left out the average American, who’s income has, in real terms, decreased over that time period. Did we fix that problem? We did manage to save the banks and the people who got us into this problem in the first place (and the last few mind you), so did we learn anything? What’s to keep us from repeating ourselves?
We saved the patient from his heart attack, but the plaque of the dying middle class will continue right on thickening because the system wont change. We haven’t been forced to learn anything. What’s to keep us from having another heart attack in 5 years? Can we afford another one? How many heart attacks can we afford?
I’m suspicious of the “recovery,” because we’ve had so many recoveries that left most Americans behind. Increasingly so, in fact, with each new “recovery.” If this recovery leaves most Americans behind, as the last few have, then I think it’s a misnomer to call it a recovery at all. For the average American we’ve been, more or less, in a recession since the 70s. When that ends, I will call a recovery with you guys.
Ben
Leo,
I’m surprised to hear you assert that California’s housing market has bottomed. I would really like to see where that comes from, given that the moratorium on foreclosures just got lifted, Option ARM resets are just starting to roll in, and the state itself in teetering on insolvency.
I’m not in Cali, but I’ve been watching that market since March 2007 knowing the types of debt that were used to fuel that housing boom.
Between increasing unemployment in that state (over 12 on the ‘official’ count) and the fact that well over half of all homes with mortgages have negative equity and that jumbo conforming loans are showing considerable strain, I see the CA market at considerable risk for further downward pressure on housing.
Well said Ben. There is much truth in those words of yours. I think many of the so called “professionals” expounding on topics such as what this post is about, fail to see the forest because of the trees.
Arlen
Following up what Ishmael wrote:
GDP is an income statement. We also need a balance sheet, which would measure not only financial health (debt) but also tangible assets (infrastructure, resources). Much of our growth has been not only debt-fueled, but accomplished through environmental destruction.
GDP goes up after hurricanes, as housing is rebuilt, but we don’t register the loss.
Two more things: we can distinguish between recovery (returning to previous levels of production) and expansion (going beyond the previous benchmark), and adjust for population. We are in for a long recovery.
And it’s also useful to compare output with potential GDP, as estimated by the CBO. Historically, we have fallen below potential in recessions, and then surpass potential GDP at the height of expansions. The last recovery was the first post-war recovery not to make it back to potential GDP. We will be far short of potential for many years to come.
the less healthy we are the higher the GDP, the more we pollute and then spend money to clean it up the higher the GDP, if I take care of your children and you take care of mine and we each pay the higher the GDP. This last part is really important- we have transferred so many services into the officially compensated sector resulting in higher GDP but in fact we are no better off. Day care and home cooked meals that were done by Mom are now paid for.
Bottom line the GDP statistics are a joke as measure of how well a society is doing. BTW part of Obama’s plan is to slow medical expenses. That is 17% of the economy (GDP) that is not expected to grow. So the remaining 83% has to grow at 5% plus to meet his target.
Oh the swine flu- the more of us who fall ill and need service the better it is for GDP growth!!!
Hi.
The U.S. GDP figure does not take into account the depletion of finite resources that go into production nor does it take into account environmental costs like global warming. Add to that the fact that U.S. GDP has been gradually shifting to other countries (mostly hostile to U.S. foreign policy) and what you have at the end is basically a meaningless figure—a bozo figure, to be exact.
Cheers,
~Peter
136 bn $ annualized inventory reduction equals 1 % of GDP, right?
I’d say it is certainly not negligible as an effect, but it won’t be enough if consumption falls due to unemployment and deleveraging.
Unless your assumption is that inventories won’t just go to zero, but will start increasing quite significantly.
Any idea when government spending will kick in more than it has done so far? Is Q2 still too early to expect a major impact?
The comments here make some of the counter-points to a Q3 positive argument. Let’s sum them.
As with you, Ed, I’m much concerned on the impact of the failure of commercial re. Whereas subprime was a bellyful of 00 buck to the big financials, com re will be two barrels of birdshot at the regional and midsize banks. Yes, the true impact won’t really be felt until Fall; we’re speaking more of another September Moment, but the problem is not small.
It is hard to discern and real ‘bottom’ to residential re _as a whole_. Prime loans are only just starting to implode, another huger problem very little of which will be at the GSEs, and hence much in the banking system. Option ARMs are a rolling problem for another what? two years. A lot more depressed repos are going to come on the market. We have a flattening of the curve, but even that is largely dependent upon the fact that the government _is_ the mortgage market, now.
I am far from expert on this point, but that said I question whether the true downdraft of consumer spending from employment loss has hit the economy yet. Discretionary areas such as travel have taken a big, big hit. It’s less clear that dining and entertainment have had the Big Bite put on ’em. Many are living on savings and plastic on the six-month swim-for-it to the next job. Which likely isn’t going to be there. It we are at 11-12% off work by the Fall, which all think likely, we should expect another big incremental decline in spending. Who is that going to look coming on Christmas for a retail economy which lives and dies with second half spending?
Is there going to be any demand pull ex-USA to boost our exports? It’s hard to see now. To the extent to which we have an ‘inventory bounce’ how much of that is going to show up in Japan, China, and Germany as real profits as opposed to shelf-stock in the US which sits awaiting buyers who are not much in evidence. That leaves aside the issue of how the ‘transition’ at Chrysler and GM to follow impact the financial system. Maybe we muddle through; maybe it blows.
I as you think we’ll get a little inventory bounce, and that the powers that be will crow blue sky over it the summer through. Not so much. As you say yourself, spending and inventory will not remotely return to recent levels, hence where is the sustain for money in motion? And as other commentors have remarkek this inventory bounce will all be debt-financed. WHERE ARE THE PROFITS? Are the major banks lending into the real economy? (Answer on the last: no.) The major point to me is that it doesn’t look like we are even half way through the _losses_ from the blow-out, so it is hard to make a case for ‘recovery,’ statistical artifacts to a dead civilization nothwithstanding.
When one falls from a height, it’s seldom straight to the bottom; usually, hone hits an outcrop first. And there’s a bounce. Then ‘progress’ continues, slower and deflected, to a true bottom. That might make for, I don’t know, a hockey-stick-shaped redepression.
Junk from space…>
The drop in foreign imports to the United States actually boosted the Q1 GDP by 6.05%. Without this adjustment, the GDP in Q1 would have been a stunning -12.15%.
In their analysis the EPI (Economic Policy Institute) found that while consumption was up slightly in past recessions we have actually seen a decline in consumption by several percentage points. The decline in investment was about 60% worse, and the decline in exports and imports was each about 75% worse than the average in previous recessions.
The last quarter of 2008 and the first quarter of 2009 together posted the worst half-year of GDP performance in over 60 years. While coming quarters may see a moderation in the pace of decline, it’s clear that this recession is already a standout in its severity and will only get worse.
The decrease in GDP in the 1st quarter reflected negative contributions from exports (down 30%), private inventory investment, equipment and software, nonresidential structures, and residential fixed investment that were partly offset by a positive contribution from personal consumption expenditures which composes nearly 2/3 of the gross domestic product. Imports (down 34.4%), which are a subtraction in the calculation of GDP, decreased. Coupling the decrease of the first quarter with the 4th quarter, this is the worst contraction of GDP this country has experienced in over 60 years.
Sivaram – consider the case where I am short of income and savings to buy a pair of shoes – and do so using a credit card in the expectation that I can pay out of future income. The transaction for that comsumable should not immediately add to GDP.
Instead I go to the bank and borrow money to start a shoe factory (to undercut Asia – naively or not!) with the expectation that the bank will get paid from future income. Those transactions should count in GDP.
This is an important disticntion which makes reported changes in GDP meaningless as they are.
I also agree fully with resource depletion argument – a national “balance sheet”.
Ed,
you are missing a huge inflator: government borrowing. fudging growth by borrowing money against future income is hardly growth. this number should be subtracted from the product produced.
the situation is identical to a homeowner drawing on a HELOC and inflating his personal income.
The biggest problem that I have with GDP is the implicit assumption that all costs are at fair value. Whilst that is plausible in the private sector, where the government is pushing money to stimulate the economy, fair value may be that last thing on their mind, provided that the costs can be covered by borrowing. More GDP is good and value for money be damned.
Public sector GDP has increased 80%since 2001, while in the private sector it is up by around 20%.
That is why in the UK government spending has risen to 50% of GDP and there is a budget deficit equal to 25% of government spending. All done in pursuit of GDP growth with questionable value and wrecking the private sector.
There are two things I want to pick up on here. Firstly we here that there has been a massive inventory purge, but there are also reports that the purge was not that great. I think the answer lies somewhere in between and depends on the particular item for sale. During quarter 4 of last year there was a retail purge of inventory as retailers slashed prices and that is now over. During quarter 1 of this year retailers have been cautiously raising inventory while all the time slowly pushing prices up to test consumers willingness to buy. Inventory will not go back to where it was and any rebound from the over selling in quarter 4 is over.
The next thing I have a problem with is the idea that exports and imports go up and down together just not in the same proportion. Yesterday there was a good article in the links about vertical specialisation from a Japanese point of view and it struck me that imports and exports must have a tendency to balance out. The implication of this is as Japanese firms cut back due to lack of demand in the US they will cut US services that they employ. The risk is that non food exports will begin to tank over the next month or two setting of another wave of reduction in demand. In other words this could be a time lagged feedback loop.
I guess I am just not happy with looking at US GDP in isolation from Europe, China, Japan and others.
I read somewhere that once a governments debt ratio to GDP reaches over 60% the country is toast. I think it was David Walker. Why isn’t this consideration figured into the scenerio?
A lot of good comments. It will be interesting to see what Leo has in store for us at the weekend.
I have a few comments too. A lot of you have mentioned two things in particular.
One, that the last generation of growth in the U.S. has not benefited the middle class. I would agree and suggest you take a look at two posts I wrote on this theme (the first takes this issue head on and the second shows the data underscoring this):
http://www.creditwritedowns.com/2008/03/populist-interpretation-of-latest-boom.html
http://www.creditwritedowns.com/2008/06/chart-of-day-real-hourly-earnings.html
My own view is that globalization has benefited the owners of capital in the U.S. and workers in our trading partners at the expense of U.S. workers.
Second, there was a lot of discussion about what GDP does not compute like externalities for one thing. To my mind, this is a perfect reason government must exist to correct the lack of incentive we all have to deal with things like the environment, long-term infrastructure building etc. Relying only on market forces to do this will lead to underinvestment in things not captured in GDP and similar measures.
As for GDP as an income statement and other measures as a balance sheet, I agree 100% with that line.
My question to all of you is what is different about today than 1990-1991 or 2001-2002? My answer is the incipient deleveraging on a scale we didn’t see in those garden variety recessions. But, it is not axiomatic that this will lead to enough deleveraging. Geithner, Summers and Bernanke are trying to reflate and this means more leverage. They may just succeed (with the help of inflation to erode the real value of debts).
One last thing, you’ll notice I said at some point, “when comparing one quarter to the next, unless you purge just as much stuff or unless demand goes down…” I happen to think consumption from Q1 was too high and will decline. The post-war average for consumption as a percentage of GDP is 66%. We have seen a massive run up from the 62-63% range in the 1970s to about 70% today. That is clearly unsustainable. So, while I do think Q3 or Q4 will show positive GDP growth numbers, it is not a done deal. In any event, the over-consumption meme does point to a less than robust expansion.
Ed,
Re: "The post-war average for consumption as a percentage of GDP is 66%. We have seen a massive run up from the 62-63% range in the 1970s to about 70% today. That is clearly unsustainable."
> Are you looking at nominal or real values there?
Doc, I’m looking at nominal. But, I believe it’s about the same for real GDP.
Thanks Ed,
The difference does seem slight, but maybe it’s PCE as a source of confusion, e.g: “The decrease in real GDP in the first quarter primarily reflected negative contributions from
exports, private inventory investment, equipment and software, nonresidential structures, and residential
fixed investment that were partly offset by a positive contribution from personal consumption expenditures (PCE). Imports, which are a subtraction in the calculation of GDP, decreased”.
The concept of PCE always seemed like a recent (distortion) invention, so I don’t know how you look at that in terms of post war adjustments, in regard to your value of 66%…
I’m just curious and not on top of this, so any clarity is appreciated. Thanks
Just to beat a dead horse, Wiki provides this:
Unlike some price indexes, the GDP deflator is not based on a fixed basket of goods and services. The basket is allowed to change with people’s consumption and investment patterns[2]. (Specifically, for GDP, the “basket” in each year is the set of all goods that were produced domestically, weighted by the market value of the total consumption of each good.) Therefore, new expenditure patterns are allowed to show up in the deflator as people respond to changing prices. The advantage of this approach is that the GDP deflator reflects up to date expenditure patterns. For instance, if the price of chicken increases relative to the price of beef, people would likely spend more money on beef as a substitute for chicken. A fixed market basket measurement would miss this change.
In practice, the difference between the deflator and a price index like the Consumer price index (CPI) is often relatively small. On the other hand, with governments in developed countries increasingly utilizing price indexes for everything from fiscal and monetary planning to payments to social program recipients, the even small differences between inflation measures can shift budget revenues and expenses by millions or billions of dollars.
Have a great day, and I enjoyed your post!