Chapter 1 MEASURING A NATION'S INCOME

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5. Real Versus Nominal GDP

a. There are two possible reasons for total spending to rise from one year to the next.

1. The economy may be producing a larger output of goods and services.

2. Goods and services could be selling at higher prices.

b. When studying GDP over time, economists would like to know if output has changed (not prices).

c. Thus, economists measure real GDP by valuing output using constant prices of a base year.

d. A Numerical Example

1) Two goods are being produced: hot dogs and hamburgers.

Year	Price of Hot Dogs	Quantity of Hot Dogs	Price of Hamburgers	Quantity of Hamburgers
2010	$1	100	$2	50
2011	$2	150	$3	100
2012	$3	200	$4	150

2) Definition of nominal GDP: the production of goods and services valued at current prices.

Nominal GDP for 2010 = ($1 × 100) + ($2 × 50) = $200.

Nominal GDP for 2011 = ($2 × 150) + ($3 × 100) = $600.

Nominal GDP for 2012 = ($3 × 200) + ($4 × 150) = $1,200.

3) Definition of real GDP: the production of goods and services valued at constant prices of a base year.

Let's assume that the base year is 2008.

Real GDP for 2010 = ($1 × 100) + ($2 × 50) = $200.

Real GDP for 2011 = ($1 × 150) + ($2 × 100) = $350.

Real GDP for 2012 = ($1 × 200) + ($2 × 150) = $500.

e. Because real GDP is unaffected by changes in prices over time, changes in real GDP reflect changes in the amount of goods and services produced.

f. The GDP Deflator: a measure of the price level calculated as the ratio of nominal GDP to real GDP times 100.

1) Example Calculations

GDP Deflator for 2010 = ($200 / $200) × 100 = 100.

GDP Deflator for 2011 = ($600 / $350) × 100 = 171.

GDP Deflator for 2012 = ($1200 / $500) × 100 = 240.

Inflation rate is the percentage change in some measure of the price level from one period to the next. 

For the previous example:

Inflation rate in 2011=(171-100)/100*100%=71%

Inflation rate in 2012=(240-171)/171*100%=40%