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The GDP deflator is one way in which inflation is measured. Inflation is the continued increase of prices over time. Despite various policies that have effects on the level of inflation it is always caused by printing money.

The GDP deflator is derived by dividing the total Gross Domestic Product at current prices by total Gross Domestic Product at constant prices. The data on current prices usually comes, at least partially, from the Consumer Price Index. The data used for constant prices is taken from a base year. Which year is being used currently depends upon which country the GDP deflator is being calculated in.

GDP can be measured using the expenditure approach which examines the total spending on goods and services within and economy. Alternately, GDP can be measured using the income approach which looks at the amount of money brought in from selling goods and services. Since somebody pays a dollar for each dollar that someone gets, the two values are equal. This is what people mean by the circular nature of spending.

GDP measured in either of the above ways is then re-valued according to the constant set of prices from the base year. The value of GDP in present dollars is then divided by the value of GDP in the dollars of the base year. This gives an indication of the extent to which the value of the dollar has changed and hence the rate of inflation.

The figure determined by the above system is expressed as an index. This means that the figure for the base year is given a value of 100. Values of the GDP deflator for subsequent years are calculated to show their value relative to this base.

Unlike the Consumer Price Index, which only examines the changes in prices for a particular basket of goods, the GDP deflator is supposed to measure changes in prices across the entire economy. This may make it a more accurate measure of the rate of inflation. It must be remembered, however, that the Consumer Price Index is used to calculate the value of the current year prices. This passes on some of the error in the CPI to the GDP Deflator.

In any case, it is the general consensus among economists is that both of these tools overstate the rate of inflation slightly. Having an accurate measure of the rate of inflation is extremely important since price stability is one of the two fundamental goals of a central bank. The way this is accomplished, using monetary policy, is by controlling the interest rate used by the central bank. Since raising this rate cuts inflation but stifles business, a balance must always be found between the two. People disagree where this balance should lie, but an accurate measure of the rate of inflation, which the GDP deflator tries to provide, is vital in any case.

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