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Lesson summary: Real vs. nominal GDP

AP.MACRO:
MEA‑1 (EU)
,
MEA‑1.I (LO)
,
MEA‑1.I.1 (EK)
,
MEA‑1.I.2 (EK)
,
MEA‑1.J (LO)
,
MEA‑1.J.1 (EK)
,
MEA‑1.J.2 (EK)
In this lesson summary review and remind yourself of the key terms and calculations used in calculating real and nominal GDP. Topics include the distinction between real and nominal GDP and how to calculate and use the GDP deflator.

Lesson Overview

Even GDP needs to keep it real. When we calculate GDP using today’s prices, we are creating a measure called nominal GDP. However, prices can change even if output doesn’t change. Because of that, our measure of output might get distorted by something like inflation.
We account for this using real GDP, which is a measure of GDP that has been adjusted for the price level. In this way, real GDP is a truer measure of output in an economy. There are two approaches to adjusting nominal GDP to get real GDP: 1) using the same prices every year or 2) using the GDP deflator.

Key Terms

TermDefinition
nominal GDPthe market value of the final production of goods and services within a country in a given period using that year’s prices (also called “current prices”)
real GDPnominal GDP adjusted for changes in the price level, using prices from a base year (constant prices) instead of “current prices” used in nominal GDP; real GDP adjusts the level of output for any price changes that may have occurred over time
GDP deflatora price index used to adjust nominal GDP to find real GDP; the GDP deflator measures the average prices of all finished goods and services produced within a nation’s borders over time.
base yearthe year used for comparison in the determination of price changes using the GDP deflator price index; the deflator in a base year is always equal to equals, 100.
current pricesthe prices at which goods are sold in a nation in a particular year; current prices are used when calculating nominal GDP.
constant pricesthe prices from a base year that are used to calculate real GDP in other years; this allows for a more accurate measure of how a country’s actual output changes over time, because using constant prices cancels out any changes in the price level between years.

Key takeaways

Definitions of nominal v. real GDP

Nominal GDP is a measure of how much is spent on output. For example, in Canada during 2015, start text, C, A, N, space, end text, dollar sign, 1, comma, 994, point, 9, start text, space, b, i, l, l, i, o, n, end text was spent on the goods and services produced in Canada. Nominal GDP measures aggregate output (meaning the value of all of the final goods and services produced) using current prices. In other words, these figures reflect the amount spent on Canada’s output in the country’s prices in 2015.

Real GDP weighs output using prices from a base year

Real GDP is a measure of how much is actually produced. Real GDP measures aggregate output using constant prices, thus removing the effect of changes in the overall price level. For example, in 2015 the value of Canada’s output expressed in constant 2010 prices was start text, C, A, N, space, end text, dollar sign, 1, comma, 857, start text, space, b, i, l, i, o, n, end text.
Here’s another way to think about Real GDP: if we add up all of the output that was produced in Canada during 2015 by using the prices that these goods sold for in 2010, the value of GDP in Canada is dollar sign, 1, comma, 857, start text, space, b, i, l, l, i, o, n, end text. But if we add up all of the output that was produced in Canada during 2015, using the prices that they sold for in 2015, the value of GDP in Canada is dollar sign, 1, comma, 995, start text, space, b, i, l, l, i, o, n, end text. This means prices must have increased between 2010 and 2015.
However, there is a slight problem with the method above. Calculating real GDP by weighting final goods and services by their prices in a base year can lead to an overstatement of real GDP growth because the prices of some goods decrease over time. Therefore, this method overstates growth in real GDP because it makes it seem like goods make up a bigger share of spending than they really do.

The GDP deflator and real GDP

Another method of calculating real GDP involves converting nominal GDP to real GDP by using the GDP deflator, which tracks price changes of a nation’s output over time. Canada’s GDP deflator for its base year of 2010 was 100 since this is the year against which prices are compared. By 2015 the deflator had increased to 107, point, 4, indicating that the average prices of Canada’s output had increased by 7, point, 4, percent.
By expressing 2015’s output in 2015 prices, therefore, Canada’s output would appear to have increased by 7, point, 4 more than it actually did. Canada’s nominal GDP, which has been “inflated” by higher prices, can be “deflated” by dividing the country’s nominal GDP of start text, C, A, N, space, end text, dollar sign, 1, comma, 994, start text, space, b, i, l, l, i, o, n, end text by the deflator expressed in hundredths.

Key Equations

\begin{aligned} \text{Real GDP} &=\dfrac{\text{Nominal GDP}}{\text{GDP deflator (in hundredths)}}\\\\\text{Nominal GDP}&=\text{Real GDP}\times\text{GDP deflator (in hundredths)}\end{aligned}

Common misperceptions:

• An increase in GDP does not necessarily mean a nation has produced more output; it must be specified whether the GDP in question is nominal or real. An increase in nominal GDP may just mean prices have increased, while an increase in real GDP definitely means output increased.
• The GDP deflator is a price index, which means it tracks the average prices of goods and services produced across all sectors of a nation's economy over time. With this index, changes in the average price level (inflation or deflation) can be calculated between years. However, this is not the most commonly used price index for tracking inflation and deflation. The consumer price index (CPI) is the most commonly used price index, which you'll learn more about later in this course.

DIscussion questions

• Why could calculating GDP each year using current prices overstate or understate changes in actual output year to year?
• Why do increases in real GDP indicate an improvement in living standards, whereas increases in nominal GDP might not?
• The table below shows the output and the prices of Switzerland in 2017 and in 2018.
Goods produced2017 price2017 quantity2018 price2018 quantity
Chocolatedollar sign, 2400dollar sign, 3400
Cheesedollar sign, 6200dollar sign, 8200
Watchesdollar sign, 2080dollar sign, 22100
a) Calculate Switzerland’s nominal GDP in (i) 2017 and (ii)2018.
b) Calculate Switzerland’s real GDP in 2018 using constant 2017 prices.
c) Calculate the GDP deflator price index for 2018. How much did the average price of goods produced in Switzerland change between 2017 and 2018?

Want to join the conversation?

• Why in a) ii for cheese 8 was multiplied by 210 while in question we have 200?
• what will be France's per capita real GDP be in 2045, given GDP of $28900 in 2003 with growth of 1.9%. Growth the same. How do you calculate? (3 votes) • I don't understand how growth can be overstated in real GDP because of the method it's computed. Any help would be appreciated. Edit: found this in the December 1995 issue of a publication by the Federal Reserve Bank of New York, in case anyone's experiencing the same problem: " An extreme example illustrates this phenomenon. Consider two products: computers and the economist’s favorite, widgets. Assume that widgets are made of the same materials as computers and require the same amount of labor to assemble. In 1987, computers cost more to buy than widgets, but in 1995 one widget sells for the same price as one computer. Suppose the owner of a widget factory decides in 1995 to change production to computers by simply switching a knob. Has aggregate real output increased? Surely not. Nothing in particular has changed, except that the boxes coming off the assembly line are now labeled “computers” rather than “widgets.” However, BEA’s statisticians, seeing the switch in the factory’s production and applying the fixed-base-year technique, note an increase in the value of the factory’s output in 1987 dollars and decide that the switch has increased real GDP. If the change had been made in 1987, the reported increase in real output would have been reasonable because the factory switched to making what was then a more valuable product. However, registering the 1995 switch as an output gain makes little sense given that computers and widgets sell for the same price in 1995. There is no objective measure indicating that manufacturing computers in 1995 is a more productive activity than manufacturing widgets." (2 votes) • Suppose the amount of output doesn’t change in an economy, but the consumer price index (CPI) increases. What happens to nominal gross domestic product (GDP) and real GDP? (2 votes) • How would you find the real GDP of the base year? (1 vote) • The real GDP of any year is found by using the prices of goods and services in the base year. For the base year, the nominal GDP is calculated using the prices in the same year itself. So, the Real GDP is equal to the nominal GDP in the base year (1 vote) • If inflation increases, will real gdp decrease? (1 vote) • Nominal GDP in the base year 2005 was$80 billion. The CPI in 2010 was 1000 and Nominal GDP experienced a growth of 5% between the years 2005 and 2010. Taking all of the above into consideration, calculate Real GDP as measured by the base year (2005) prices