Letters to the Editor – Response to W.A. Wijewardena on GDP per capita by R.M.B. Senanayake
W.A. Wijewardena faults me for using the GDP deflator as a proxy measure for general price level inflation. GDP deflator refers to a general price level and it is often used as a proxy to measure inflation in the economy.
There is a well-known rule of thumb which tells us that the rate of inflation is equal to the rate of money growth plus the rate of increase of velocity minus the rate of growth of real GDP. The money supply increased by 19.8% in 2011, the velocity of circulation declined marginally from 2.92 in 2010 to 2.85 in 2011 and the real GDP growth rate was 8.3%. So the rate of inflation should be 11.4%.
I know this is only a rule of thumb but it indicates that our official inflation figures are too low. The GDP deflator of 7.8% is in my opinion a better indicator of inflation in the general price level although it does not reflect the price level of net exports.
I don’t agree with WAW that the GDP deflator cannot be used as a proxy measure for inflation. Of course it is not measuring the same thing. The Consumer Price Index attempts to measure how the prices of a typical market basket of goods changes over time. The idea is to measure the impact of price changes on the consumption bundle of the average household. That’s not what the GDP deflator measures.
Just as we can think of a typical bundle of goods that a household consumes, we can also think about the price of a unit of GDP. GDP is composed of four elements, consumption, investment, government spending, and net exports. For example, real GDP might be 600 Cs, 200 Is, 150 Gs and 50 NXs. If so, we can think of a unit of GDP as .6 units of the consumption good, C, .2 units of the investment good, .15 units of the investment good, I, and .05 units of net exports.
I agree with WAW that the GDP deflator will not reflect properly the price changes in net imports. But economists know the difference and they use the GDP deflator only as a proxy for inflation in the general price level which is what is relevant for the issue at hand regarding the proper exchange rate to be used for the conversion of the nominal GDP to dollars.
Several economists use the GDP deflator as a proxy for inflation when there is doubt about the consumer price inflation measure. Many governments tend to underestimate consumer price inflation because it is often linked to wages where they are often indexed.
Unlike some price indexes (like the CPI), 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. Therefore, new expenditure patterns are allowed to show up in the deflator as people respond to changing prices. The theory behind 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, it is claimed that people will likely spend more money on beef as a substitute for chicken.
In practice, the difference between the deflator and a price index like the Consumer Price Index (CPI) is often relatively small, according to Wikipedia the online encyclopaedia.
The Inflation; GDP deflator (annual %) in Sri Lanka was last reported at 7.27 in 2010, according to a World Bank report released in 2011. The Inflation; GDP deflator (annual %) in Sri Lanka was 5.88 in 2009, according to a World Bank report, published in 2010.
The Inflation; GDP deflator (annual %) in Sri Lanka was reported at 16.33 in 2008, according to the World Bank. Inflation as measured by the annual growth rate of the GDP implicit deflator shows the rate of price change in the economy as a whole. The GDP implicit deflator is the ratio of GDP in current local currency to GDP in constant local currency.
Please see the website www.gdpdeflator.com of the US Bureau of Economic Analysis: “The GDP deflator is an economic measure that tracks the cost of goods produced in an economy relative to the purchasing power of the dollar.” Also visit the website of H.M Treasury Gross Domestic Product (GDP) deflators: A user’s guide. In fact cross country inflation rates are often analysed from GDP deflators. Please refer to the World Development Report 2006.
WAW also refers to purchasing power parity and implies that I said that the nominal GDP is the purchasing power parity. I must confess that I have made a typing error for the figure $ 2,936 refers to the nominal GDP figure published by the Central Bank. It is apparent from the figure that it was an error since we do not have published PPP rates of exchange.
The PPP exchange rate is obtained by dividing the purchasing power of the dollar by the purchasing power of the Rupee in respect of a similar basket of goods. What I meant was that the World Bank has accepted our country status as lower middle income country. The World Bank uses the Atlas method of conversion. True that the Central Bank has used an overvalued exchange rate and as Dr. Harsha De Silva pointed out, some caveat on this matter would have been prudent.