Nominal vs Real GDP
Another concept we need to understand is the difference between nominal vs real GDP. We know that the components C, I, G, EX, and IM are calculated at current market prices. But since we are interested in comparing the GDP figure year over year basis we need to deflate this number and we will see how this deflation is done.
We will see in this example that a change in the GDP growth rate can be attributed to two factors -Â
1) changes in the composition of GDP, for example, an increase in consumer spending, or 2) changes in prices.
Figure: GDP Growth can be Attributed to Change in Quantity and Change in Price
Letâ€™s take an example of a simple economy that sells only one productâ€”butter. If the consumption of butter in 1984 was, for example, 10 million kg and the price of butter was for example, $10 per kg then our total consumption would be $100 million; so our nominal GDP would be $100 million in 1984 prices.
Now letâ€™s assume that in 1985 the consumption increases to 11 million kg. However, the price of butter increased to say $12 per kg due to a shortage of milk. So in 1985 our GDP increases, due to consumption expenditure, to $132 million, since we are measuring GDP in 1985 market prices. We see that our nominal GDP has gone up by 32%.
However, we know that this 32% increase in GDP is an illusion partly due to the 20% increase in the price of butter. Therefore, we need to deflate this number to bring prices back to a base year’s price, which is 1984’s price in this case. We deflate the nominal GDP by dividing by the current year’s price and then multiplying by the base year’s price.
Real GDP = (132/12)*10 = 110, which is equivalent to a growth rate of 10%, the same rate as the increase in the quantity of butter produced from 1984 to 1985. Post deflation we can see how much of the GDP growth is due to a â€œrealâ€ increase and what is the â€œnominalâ€ increase in GDP.
We shall study more about deflators of GDP in the inflation chapter, specifically two deflators that are estimated in the quarterly GDP release by the Commerce Departmentâ€”the implicit price deflator and the fixed weight deflatorâ€” but for now it is important to understand the difference between real and nominal GDP as these terms will be used throughout the rest of the book.
We can take note of an interesting observation in this hypothetical single product economy above where the only product produced is butter. We see that in order to â€œdeflateâ€ the nominal GDP we divided it by the current year’s price of butter. Since this is a single product economy where we have a single price we can easily divide the total goods produced (monetary amount $132 million) in order to get back the units produced and then multiply by 1984’s price.
However, in the real world with hundreds of thousands of goods and services produced, all at different prices, it is not possible to divide each amount by the price to calculate the unit volume so that we can multiply by the base year’s price. An alternative solution to this is to divide the aggregate goods and services produced or consumed by an â€œindex.â€
This index is a representative basket of goods and services produced in the economy. There are generally multiple indices produced in an economy such as the consumer price index, the producer price index, and GDP deflators. Therefore, in a complex economy with thousands of goods and services deflating the GDP will look like theÂ example below.Â We will study more on indexes and inflation in the inflation section.
Figure: GDP Deflators