APMacro: Nominal GDP v Real GDP

GDP image
Gross Domestic Product is a measure of the market or money value of all final goods and services produced by the economy in a given year. We use money or nominal values as a common denominator in order to sum that output into a meaningful number. But it creates a problem on how can we compare the market values of GDP from year to year if the value of money changes in response to rising prices or falling prices. The way around this problem is to deflate GDP when prices rise and to inflate GDP when prices fall. These adjustments give us a measure of GDP for various years as if the value of the dollar had always been the same as it was in some reference year. a GDP based on the prices that prevailed when the output was produced is called unadjusted GDP or nominal GDP. A GDP that has been deflated or inflated to reflect changes in the price level is called adjusted GDP or real GDP.

There are two ways to adjust nominal GDP to reflect price changes. One way is to assemble data on price changes that occurred over various years and use them to establish an overall price index for the entire period. Then we can use the index in each year to adjust nominal GDP to real GDP for that year. A price index is a measure of the price of a specific collection of goods and services, called a market basket, in a given year as compared to the price of an identical collection of goods and services in a reference year. That point of reference or benchmark is known as the base year. The price ratio between a given year and the base year is multiplied by 100.

Price Index = (specific year market basket / base year market basket) x 100

We can now use the index number to deflate the nominal GDP. The simplest and most direct method of deflating is to express the index number as hundredth, in decimal form, and then to divide them into corresponding nominal GDP. That gives us real GDP.

Real GDP = nominal GDP / price index (in hundredth)

Another way to establish real GDP is to gather data on physical outputs and their prices. we could then determine the market value of outputs in successive years if the base year prices had prevailed. Once we have determined real GDP through this method, we can identify the price index for a given year by dividing the nominal GDP by the real GDP for that year.

Price Index = nominal GDP / real GDP

1) Read Chapter 6.3 pp,116-118 & 6.4 pp.118-121



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