3: Nominal vs. real GDP

Nominal vs. Real GDP

Nominal GDP measures a country's total economic output using current market prices during the year it was produced. It reflects the raw monetary value of all final goods and services. For example, if an economy produces 100 cars at $20,000 each in Year 1, nominal GDP is$2$million. If production remains 100 cars in Year 2 but prices rise to$22,000 each, nominal GDP becomes $2.2$ million.

Real GDP adjusts for inflation or deflation by valuing output at constant prices from a chosen base year. This isolates changes in physical production from price fluctuations. Using the car example, if Year 1 is the base year, real GDP in Year 2 is calculated using Year 1’s prices: 100 \text{ cars} \times \20,000 = $2$ million (same as Year 1). This shows zero growth in actual output, despite nominal GDP rising.

Why Both Metrics Matter

• Nominal GDP is essential for assessing current economic size and tax revenue but can exaggerate growth during inflation.
• Real GDP reveals true economic growth by excluding price effects. A rise in real GDP signals increased production of goods/services, while a fall indicates contraction. Policymakers and economists prioritize real GDP to gauge business cycles, recessions, and long-term growth trends.

Calculating Real GDP

1. Select a base year (e.g., 2020).
2. Multiply current-year quantities by base-year prices:
   $\text{Real GDP} = \sum (\text{Current-year quantity} \times \text{Base-year price}) \quad \text{for all goods/services}.$
   For multi-good economies:
   • Bread: 2023 quantity × 2020 price
   • Milk: 2023 quantity × 2020 price
   • Sum all products.

The GDP Deflator: Linking Nominal and Real GDP

The GDP deflator (a price index) derives from both GDP types:

$$\text{GDP Deflator} = \left( \frac{\text{Nominal GDP}}{\text{Real GDP}} \right) \times 100$$

• Example: Nominal GDP = $12$ trillion (2023), Real GDP = $10$ trillion (2020 prices).
  GDP deflator = $(12 / 10) \times 100 = 120$, indicating a $20\%$ average price rise since 2020.

Key Distinction

• Growth comparison: If nominal GDP grows $7\%$ and inflation is $4\%$, real GDP growth is $\approx 3\%$.
• Policy use: Central banks track real GDP to set interest rates; governments use it for fiscal planning.
• Limitation: Real GDP relies on accurate base-year prices. Economies update base years periodically (e.g., every 5 years) to reflect consumption patterns.