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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.

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  • leaf yellow style avatar for user catherinekent1116
    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
    (51 votes)
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  • leaf green style avatar for user Michael Javier Moreno Vargas
    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?
    (16 votes)
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    • leaf green style avatar for user SteveSargentJr
      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).
      (23 votes)
  • blobby green style avatar for user Ivan Kostyuk
    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?
    (6 votes)
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    • leaf green style avatar for user Megan
      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.
      (11 votes)
  • leaf green style avatar for user hlinee
    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?
    (0 votes)
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    • leaf green style avatar for user Namit Singal
      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%.
      (9 votes)
  • blobby green style avatar for user Jimi Benedict
    I love the way you frequently repeat the main statements that are important.
    (4 votes)
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  • blobby green style avatar for user rhinoblitzing
    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)
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    • leaf green style avatar for user SteveSargentJr
      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:
      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!
      (5 votes)
  • blobby green style avatar for user Martha Wang
    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?
    (2 votes)
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  • leaf green style avatar for user Austin Jones
    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?
    (3 votes)
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  • leaf blue style avatar for user EveryThinG.MaTteRz
    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.
    (3 votes)
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  • mr pants teal style avatar for user Cdmincorperated
    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
    (3 votes)
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Video transcript

In the last video, we studied a super simplified economy that only sold one good or service. But now let's think about things a little bit more generally, or a little bit more complex economies. And let's say that in year one economists have determined that the level of prices of the goods and services produced in that economy is 100. So they've essentially just multiplied and divided by the right numbers, so that their index that they generate just says that that is 100. And they do this so that they can measure the prices in other years relative to year one. So let's say in year two, using their index, they realize that prices are now 110. Now, this is not a simple thing to do. This would have been a very simple thing to do if there was only one good or service in the economy, like in our last example, apples. You could have just taken the price of apples. It went from $0.50 to $0.55. In the real world, this is not a simple thing to do. You have a gazillion goods and services. Some prices go up. Some prices to go down. The quantities of the goods and services change. In fact, there might be goods and services that were offered in year one that don't exist anymore in year two. And there are goods and services in year two that didn't exist in year one. But for the sake of this video, let's just assume that economists are able to say this. If you call the general level of prices 100 in year one, it's now 110. Or another way to think about it is things have gotten 10% more expensive. Now, assuming that we know this relationship-- and once again, it's not an easy thing to figure out, and it actually turns out there's no perfect way to do this-- how can we figure out a relationship between real GDP and nominal GDP? And remember, whenever we talk about real GDP-- so we're going to talk about real GDP in year two-- whenever you talk about real GDP, you're talking about GDP in terms of the prices in some base year. So in this example, we'll think about real GDP in year two in terms of a year one dollars. So whatever were the goods and services that were produced in year two, we're going to think about, well, what if they were at the same prices as in year one? And that will give us the real GDP in year two. So one way to think about it is really just a ratio. So let me write nominal GDP. So this is GDP in year two, measured in year two dollars, divided by-- I guess we could call this a proportion, really-- divided by the real GDP in year two. And this is measured in year one dollars. Well, that's going to be the same thing as the ratio of the prices between year two and year one. This is going to be the ratio of-- we use this indicator right over here-- 110 to 100. And I want you to just sit and think about this for a second. It's just saying, look, these are measuring the same goods and services. The real GDP is measuring them in year one prices. The nominal GDP is measuring them in year two prices. So if things got 10% more expensive between year one and year two, the nominal GDP should be 10% larger than real GDP. We should have the exact same ratios. And now we can manipulate this thing using any type of algebra that we want. For example, we could say, well, nominal GDP-- And I'll just write nominal now. This is where I kind of specified exactly what we're talking about. This is a nominal GDP of year two. So now we could say nominal GDP is equal to-- we can multiply both sides times the real GDP-- is equal to 110 over 100 times the real GDP. And remember, this is nominal GDP in year two. This is real GDP in year two, measured in year one dollars. Or we can divide both sides of this equation by this 110 over 100. And then we get nominal GDP in year two divided by 110 over 100 is equal to real GDP in year two. This is nominal GDP in year two. And writing it this way kind of feels like you're taking your nominal GDP in year two, and there's been a general increase in the level of prices. That's called price inflation. We see that right over here. And now we're deflating it to get real GDP. We're dividing it by the ratio of the prices. We're dividing it essentially by how much the prices have grown, or I guess you could say the ratio between the year two prices and the year one prices. So this quantity right over here is 1.1. So another way you could think about it, we're deflating the nominal GDP in year two to get the real GDP in year two. We're getting it in, remember, this is in year one prices. And because of that, this number right over here is referred to as a deflator. This is our GDP deflator. You pick a base here, in this case, it was year one. That base year could have been 1985. It could've been 2006. Who knows what it could be. It could be anything. Your GDP deflator is going to be relative to that base year. It's going to say, well, if that base here was 100, your deflator's going to say how much things are now in this year. And you can even go backwards in time. Year zero, the deflator might have been 85, because maybe things have gotten cheaper. Or you could actually had prices go down. You could have actually had deflation. So maybe in year two your deflator would be at 98. But the reason why it's called a deflator is because generally you have inflation as time goes on, and generally you're going to be deflating your nominal GDP. You're going to be dividing it by a value greater than one. It's going to be something over 100 divided by 100, which is your base year, to get your real GDP.