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### Course: Macroeconomics>Unit 2

Lesson 6: Real vs. nominal GDP

# GDP deflator

Examine the complexities of measuring prices in an economy with multiple goods and services. See how economists use an index to measure changes in prices over time, and to calculate real GDP and nominal GDP. You'll also learn about the GDP deflator, which is used to adjust nominal GDP for inflation in order to get real GDP. Created by Sal Khan.

## Want to join the conversation?

• Can you please this concept for me?
Nominal GDP: the GDP in year 2's prices
Real GDP: the GDP with inflation taken into account
• That looks right to me.
• so if an economists would want to find the real GDP of a country, he would divide it by the percentage of the inflation in that country in the given time?
• Yes, more or less. To find real GDP, you divide the Nominal GDP by a suitable price index (usually the GDP Deflator). Dividing by any other price index (such as the Consumer Price Index) is usually not appropriate because the CPI only considers Consumption goods (and not Investment goods and government expenditures).
• If a new product comes out in one year which did not exist in the year you are using as your base year how can you figure out its price in the base year? Do you just assume that it would have the same price in the base year if it would have existed at that time?
• If the product did not exist in Y1 you can use the information provided to find out what the inflation rate was from Y1 to Y2 and calculate what the products price would have been had it existed in Y1.
• Why divide nominal gdp by 1.10 to deflate it and get real gdp instead of multiply by 0.90? Why do the two answers differ?
• We do that to counter changes in prices and get the real picture. Prices were earlier at 100 and are now at 110, they have increased by 10%. Whereas by multiplying by 0.9 you are saying that the prices in the base year are 90% of that of the current year, which thus means that you are saying that the prices have increased by
(100-90)/90 i.e by 11%.
• I love the way you frequently repeat the main statements that are important.
• It's almost easier just to go with the rate of inflation and the base GDP %, find the difference and that's the Read GDP. For example, we have a 1% GDP in year 1 and a 4% GDP in year 2. Inflation is 2%. You'd find the difference between the 1st and 2nd year, which in this case is 3% rise in GDP minus the 2% inflation so REAL GDP increase between year 1 and 2 is really 1%. Or if you want to just the GDP for year 2: 4% from year 1 minus 2% inflation which gives us a REAL GDP of 2%.
(1 vote)
• The main problem with your approach is that you are assuming that you know ahead of time what the inflation rate is. In reality, the GDP deflator is one way (along with other indices such as the CPI) economists attempt to measure the rate of Inflation.

The second thing to remember (though this isn't as important as my first point) is that subtracting the inflation rate from the growth rate of nominal GDP only gives a first-order approximation of the real GDP growth rate.
Here's an example of the precise way of calculating the real GDP growth rate:
Given:
Growth in nominal GDP: 6%
Inflation rate: 2.5%
Then to calculate growth rate of real GDP:

Growth rate in real GDP = [(1.06)/(1.025) -1]* 100%
which is approximately equal to 3.415%.

This difference might not seem like a lot (i.e. compared to 3.5%) but it's especially important if you try to calculate inflation over multiple time periods. In addition, when dealing with GDP, even fractions of a percent can amount to hundreds of billions of dollars.
Hope this helps!
• Hi. I have a question about the quantity of GDP. Are both the Real GDP and the Nominal GDP based on the same quantity of goods? And is the only difference between them the inflation of price?
• Yes, the only difference between Nominal GDP and Real GDP is the inflation in price. There are no differences in the quantities of goods.
• Sorry if I am repeating already said information, but is it safe to say that real GDP is basically GDP according to a previous year, just adjusted for inflation?
• It depends on the base year you are using, it might not be of the previous year...
(1 vote)
• What exactly can be used for a deflator? I apologize if I missed an obvious point in the video, I just being 100% sure that I've grasped a subject.
• For anyone still not understanding the math:

If you think about it in simple terms, Real GDP for Year 2 is just Year 2's quantity produced multiplied by Year 1's prices. We get the quantity produced in Year 2 (the real growth) by dividing Year 2's Nominal GDP (the product) by Year 2's prices (one of its factors) to derive the other factor (quantity produced). From there, you just multiply this by Year 1's Prices to get Real GDP. So (all values are respective to Year 2 unless otherwise stated):

Nominal GDP (Y2) = Quantity * Prices
Quantity = Nominal/Prices
Real GDP (Y2) = Quantity * Year 1 Prices

Substituting Year 2 Quantity with our ratio in the second step:

Real GDP (Y2) = Nominal/(Year 2 Prices) * Year 1 Prices

This can be restated as:

Real GDP = (Nominal) * Year 1 Prices/Year 2 Prices

And since multiplying a fraction is the same as dividing by its reciprocal:

Real GDP = Nominal/(Year 2 Prices/Year 1 Prices)

Which, when you substitute the price values for indices, you get the same ratio as you would have gotten if you used the real values. This ratio deflates your Year 2 Nominal GDP so that you get Year 2 Real GDP. Hope this helped