Now that we have a better understanding of what GDP is and the various ways it’s calculated, let me present a scenario to you.

Suppose we have this economy, and in year 1, this economy’s GDP measured out to be $2,500. In year 2, the value of GDP rose to $5,000. Based on this information, what can you tell me about this economy?

“Well, it seems to me that this economy doubled its production going from year 1 to year 2, but it’s not that simple, is it? This is probably a trick question, otherwise you wouldn’t be asking me this, you say.

Your intuition is spot on. Since GDP is the measurement of an economy’s output one might think that if the value of GDP rose, it must mean production has risen as well, but that isn’t always the case. You have to remember that GDP is measured with money and the value of money changes over time due to inflation or deflation.

Let me show you what I mean. Pretend this economy is a one item economy; all they produce are toys. In year 1, this economy manufactured 250 toys and sold them for $10 apiece. That would give us our first year GDP value of $2,500 $(= \$10 x 250 toys). So far so good. Then let’s say that in year 2, this economy still produced 250 toys, but the price doubled to $20 apiece, doubling GDP to $5,000 $(= \$20 x 250 toys).

If GDP is supposed to be a measure of production, shouldn’t it remain the same between year 1 and year 2, since this economy produced the same number of toys each year?”

Indeed it should and therein lies the problem with what we call nominal GDP which is GDP that has not been adjusted for inflation. When we’re talking about GDP, the only thing we’re concerned about is output, but nominal GDP has prices as an added factor. The changing prices disguises any potential change in output.

Trying to compare nominal GDPs is like trying to compare distances that have been measured with a ruler that keeps on changing its mind about how long a foot is. You’re not going to get a meaningful result.

Economists realized this was a problem and the solution they came up with was a way to standardize prices across every time. That way, the value of $1 holds the same amount of weight now as it did 100 years ago. In other words, economists adjust GDP for inflation and that adjusted value is referred to as real GDP. With real GDP, we eliminate prices as a variable for change, so changes in real GDP reflect actual changes in output.

The easiest way to explain this is with an example, so follow along.

Nominal GDP and Real GDP Example
Here I have a two item economy that produces hotdogs and hamburgers. I have the quantities they produced each year along with the corresponding prices. Note how output falls going from year 3 to 4, but nominal GDP still increases, due to higher prices. The decrease in output however, is accurately captured in the real GDP, which falls from $170 to $110.

Calculating Nominal GDP
To calculate the nominal values of GDP of any given year, all we have to do is take the price of a good and multiply it by the quantity in the same year and sum those numbers up across all the goods. So to calculate nominal GDP for year 3, we take the price of hotdogs in year 3 ($5) multiply that by the number of hotdogs produced in year 3 (11 hotdogs) and add that to the price of hamburgers ($9) multiplied by the quantity of hamburgers (21 hamburgers). That gives us a nominal GDP of $244 $(= \$5 x 11 hotdogs + \$9 x 21 hamburgers) for year 3. You would repeat that process for all the other years to find their corresponding nominal GDP values.

Calculating Real GDP: Fixing Prices
Since we only have a two item economy, we can use a very simple method of calculating real GDP. The first thing that we have to do is select a reference year or a base year that we’re going to compare every other year to. (You can select any year you’d like. Just keep in mind that choosing different base years will give you different numbers.)Then we say to ourselves, “What would GDP be like if prices never changed throughout the years?” In other words, we fix the price so only output can change.

In this example, I chose year 1 as my base year. I see the price of hotdogs in year 1 is $4 and the price of hamburgers in year 1 is $6. So I’m saying to myself, “Let’s look at every other year’s GDP using year 1’s dollars.” So if I wanted to find out what the real GDP in year 4 was, I would take the prices in year 1 and multiply them by the quantities in year 4. This gives me a real GDP value of $110 $(= \$4 x 8 hotdogs + \$6 x 13 hamburgers).

Special note: The nominal GDP and the real GDP for your base year is always the same.

Calculating Real GDP: GDP Deflator
In the real world, there would be far too many things to keep track of in order to compute real GDP by fixing prices, especially if you were doing it by yourself. Instead, we calculate real GDP by using the GDP deflator, which is calculated by the Bureau of Economic Analysis (in the United States, anyway). They come up with the GDP deflator by tracking a market basket of goods and using a chain weighted technique to come up with their price index. If that sounds complicated, that’s because it is. Don’t worry, we won’t be covering that today. Instead, we’ll just be referring to this very simple formula:

$Real GDP = (Nominal GDP/GDP Deflator) x 100
From which we can derive: $GDP Deflator = (Nominal GDP/Real GDP) x 100
As well as: $Nominal GDP = (Real GDP x GDP Deflator)/100

This means that as long as you’re given at least two variables, you can always calculate the third. For example, let’s say that the base year is still year 1 and we want to use the GDP deflator in year 5 to calculate the real GDP for year 5. To do that, we simply take the nominal GDP in year 5 ($376), divide it by year 5’s GDP deflator (241) and multiply the result by 100 to get $156 $(= (\$376/241) x 100). If you know the nominal GDP and the real GDP for a given year, you can calculate that year’s GDP deflator. To get the GDP deflator of 145 $(= (\$206/\$142) x 100) in year 2, just take the nominal GDP of year 2 ($206), divide that by the real GDP of year 2 ($142) and multiply the result by 100. You can also rearrange the formula to solve for nominal GDP, as I did above. I’ll leave that exercise up to you so this post isn’t cluttered up with too many numbers.

Special note: The GDP deflator for your base year is always 100.

So you can see that the GDP deflator takes the inflation and deflation of prices across all the goods and services in an economy and compresses it into one neat little number. It allows us to tell, at a glance, how prices have been acting within the economy. If the deflator increases in value, it means that in general, prices have risen. If the deflator falls, it means that in general, prices have fell. In fact, the GDP deflator is one of the metrics some people use to measure inflation in an economy, but that’s a discussion for another time.
Recap (tl;dr)
-Nominal GDP does not account for inflation.
-Nominal GDP can change because prices changed or because output changed or because of a combination of the two.
-Real GDP accounts for inflation and removes price as a factor.
-Changes in real GDP reflects real changes in output.
-Nominal GDP is calculated by taking prices in a given year and multiplying it with the output in the same year and summing those numbers up across all the goods and services.
-The first step to calculating real GDP is choosing a base year.
-Real GDP can be calculated by fixing base year prices or by using the GDP deflator.
-The nominal GDP and real GDP is always the same in the base year.
-The GDP deflator is always 100 in the base year.
McConnell, Campbell R., Stanley L. Brue, and Sean Masaki. Flynn. Macroeconomics: Principles, Problems, and Policies. Boston: McGraw-Hill Irwin, 2009. Print.
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