MAcro CHAPTER 2.6:

CHAPTER SUMMARY

We now understand the concepts of GDP and inflation. This means we are ready to understand the difference between nominal GDP and real GDP.

GDP is measured in dollars (or whatever the currency of the country is), so the number going up does not necessarily mean that the economy has grown. The dollar number is called nominal GDP, and can go up for two reasons: either the economy is producing more than before, or there has been inflation. It can also be a combination of both.

Real GDP, however, is only affected by how much the economy produces, and not by inflation. It does this by "adjusting" the nominal GDP for inflation. We can do this by multiplying the number of each item produced by the price back in the base year. For example, if the base year is 1990, and we want to measure the economic value of all t-shirts produced in 2020, we multiply the number of t-shirts produced by the price of a t-shirt in 1990, instead of 2020. When we do this for all items, we can find the real GDP.

To see an example of this, take a look at the data below. Imagine that the first set of data is from 2000, and the second set of data is from 2020. First, we can calculate the nominal GDP in each year:

Nominal GDP(Year 2000) = $1*1M + $1*4M + $3*2M = $1M + $4M + $6M = $11M

Nominal GDP(Year 2020) = $2*2M + $2*3M + $5*2M = $4M + $6M + $10M = $20M

We can see that the nominal GDP has increased by 81%.

However, if we do the same calculation for both years using the Year 2000 prices, we find something different.

Real GDP(Year 2000) = $1*1M + $1*4M + $3*2M = $1M + $4M + $6M = $11M

Real GDP(Year 2020) = $1*2M + $1*3M + $3*2M = $2M + $3M + $6M = $11M

In this case, we find that, in terms of Year 2000, the value of what we produce has not actually gone up at all! That means that 81% increase in nominal GDP is all due to inflation, and not due to increases in production.

The GDP Deflator is an index that we use to turn Nominal GDP into Real GDP. If these two numbers are the same, the GDP Deflator is 100, representing that Nominal GDP = 100% of Real GDP. If there has been inflation, the Nominal GDP will be greater than 100. If the GDP Deflator is 200, this means prices have doubled, so we need to divide the Nominal GDP by 2 to get the Real GDP.

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