Real vs. Nominal GDP and the GDP Deflator
Your favorite burger place sold 1,000 burgers last year at $\$5$ each. This year it sold 1,000 burgers at $\$6$ each. Its revenue went up 20%, but did it actually serve more customers? Economists face the same puzzle with a whole country: when the GDP number grows, did we produce more, or did prices just go up? By the end of this page you will be able to answer that.
Nominal GDP vs. real GDP
Gross domestic product (GDP) is the market value of all final goods and services produced within a country in a year. Because it is a value, it equals prices times quantities, so it can change for two reasons: prices change, or quantities change.
Back to the burger place: its revenue is "nominal." Measured in last year's prices, this year's sales are still 1,000 burgers $\times$ $\$5$ = $\$5{,}000$. Nothing real changed.
In the figure, prices rose between year 1 and year 2 but output did not. The values are illustrative, in billions of dollars, and the bar heights are drawn to the same scale (the 100 and 124 marks on the vertical axis show the scale). Nominal GDP (the taller bar in year 2) grew from 100 to 124, while real GDP stayed flat at 100.
Define nominal GDP and real GDP in one sentence each. Then state which of the two can rise even when the quantity of goods and services produced does not change, and…
Define nominal GDP and real GDP in one sentence each. Then state which of the two can rise even when the quantity of goods and services produced does not change, and explain why.
The GDP deflator and converting nominal to real
The GDP deflator is a price index for everything counted in GDP. The base year is set to 100. A deflator of 120 means prices are 20% higher than in the base year.
Why does this work? Nominal GDP = prices $\times$ quantities, and real GDP = base prices $\times$ quantities. Dividing the first by the second isolates how much higher prices are than in the base year. Dividing nominal GDP by the price level "strips out" inflation.
Your answer to the Try it problem should be $\$3{,}600$ billion, since $4{,}500 \div 125 = 36$.
You can also build the numbers from quantities, as in this small economy.
An economy has nominal GDP of $\$2{,}400…
An economy has nominal GDP of $\$2{,}400$ billion in the current year. The GDP deflator for that year is 120, with a base year value of 100. Compute real GDP for the current year, in base-year dollars.
A small economy produces only pizzas and sodas. In year 1 (the base year), pizzas sell for $\$10$ and sodas for $\$2$, and the economy produces 100 pizzas and 200 sodas.…
A small economy produces only pizzas and sodas. In year 1 (the base year), pizzas sell for $\$10$ and sodas for $\$2$, and the economy produces 100 pizzas and 200 sodas. In year 2, pizzas sell for $\$12$ and sodas for $\$3$, and the economy produces 110 pizzas and 200 sodas. Compute nominal GDP in both years, real GDP in year 2 using year 1 prices, and the GDP deflator for year 2.
Growth rates
To measure how fast an economy is growing, compute a growth rate, the percentage change from one year to the next.
Use real GDP in this formula to measure growth in output. Use nominal GDP, and you mix output growth with inflation.
Real GDP in an economy was $\$20{,}000$ billion last year and $\$20{,}600$ billion this year. Compute the growth rate of real GDP. Does the result tell you anything…
Real GDP in an economy was $\$20{,}000$ billion last year and $\$20{,}600$ billion this year. Compute the growth rate of real GDP. Does the result tell you anything about whether prices rose? Explain.
An economy reports the following data. | Year | Nominal GDP (billions) | GDP deflator (base year = 100) | |---|---|---| | 1 (base year) | $\$5{,}000…
An economy reports the following data.
| Year | Nominal GDP (billions) | GDP deflator (base year = 100) |
|---|---|---|
| 1 (base year) | $\$5{,}000$ | 100 |
| 2 | $\$5{,}460$ | 105 |
Compute real GDP in year 2. Then compute the growth rate of nominal GDP and the growth rate of real GDP from year 1 to year 2, and explain why the two rates differ.
An economy reports the following data. | Year | Nominal GDP (billions) | GDP deflator | |---|---|---| | 1 (base year) | $\$18{,}000$ | 100 | | 2 | $\$19{,}440$ | 108 | |…
An economy reports the following data.
| Year | Nominal GDP (billions) | GDP deflator |
|---|---|---|
| 1 (base year) | $\$18{,}000$ | 100 |
| 2 | $\$19{,}440$ | 108 |
| 3 | $\$20{,}000$ | 111 |
(a) Compute real GDP for each year. (b) Compute the growth rate of nominal GDP and of real GDP for years 2 and 3. (c) A headline in year 2 reads "Economy grows 8%." Evaluate whether the headline accurately describes the change in output, and say in which year, if either, the economy actually produced more. Use your numbers.
Real GDP per capita and the limits of GDP
To compare living standards, economists divide by population:
$$\text{real GDP per capita} = \frac{\text{real GDP}}{\text{population}}$$A country can have a huge real GDP simply because it has many people. Per capita figures show output per person.
(Answer: $\$30{,}000$.)
Even accurate real GDP per capita is an imperfect measure of well-being. GDP leaves out or misjudges several things:
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Unpaid work: housework, caring for family, and volunteering are not sold in markets, so they are not counted.
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The underground economy: cash jobs and illegal activity are unreported, so GDP understates output.
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Leisure: a country where people work fewer hours may be better off, but GDP does not show it.
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Environmental damage and quality of life: pollution is not subtracted. Cleaning up an oil spill even adds to GDP.
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Distribution: an average hides who gets the income.
Country A has a higher real GDP per capita than Country B. However, people in Country B work fewer hours, spend more time on unpaid household work and volunteering, and…
Country A has a higher real GDP per capita than Country B. However, people in Country B work fewer hours, spend more time on unpaid household work and volunteering, and live with much cleaner air. Explain two reasons real GDP per capita may be an imperfect measure of well-being when comparing these countries. Give one example of an activity GDP leaves out and one example of something GDP counts that may not raise well-being.
A country has nominal GDP of $\$900…
A country has nominal GDP of $\$900$ billion, a GDP deflator of 150 (base year = 100), and a population of 20 million people. (a) Compute real GDP and real GDP per capita (in dollars per person). (b) Suppose an underground economy equal to 10% of reported real GDP goes unrecorded. Compute the true real GDP per capita, assuming the unrecorded output is valued at base-year prices. (c) Explain why even accurate real GDP per capita may fail to capture well-being, giving two specific limitations.
Back to the burger place: revenue rose 20%, but the number of burgers stayed at 1,000. In real terms (at last year's price of $\$5$), sales were unchanged. The 20% was all price.