2.6 - Real v. Nominal GDP
Nominal vs. Real Variables
GDP () is the big one in macro, representing total spending in an economy.
- Nominal variables are the numbers you see in everyday life, like a nominal wage of $12/hour or a nominal interest rate of 5%.
- The problem with nominal numbers is they don’t account for inflation. A high nominal wage doesn’t mean much if prices, like bread at $50 a loaf, are also sky high.
- Real variables control for changes in the price level, letting you compare across time using a consistent base.
Calculating Real Variables
- Real wage: . Example: a price level of 150 and nominal wage of $15 gives a real wage of $10.
- Real income: . Example: a price level of 120 and nominal income of $24,000 gives a real income of $20,000.
- Real interest rate: Nominal Interest Rate minus Expected Inflation Rate. Example: a nominal rate of 5% minus expected inflation of 4% gives a real rate of 1%.
Nominal GDP vs. Real GDP
- Nominal GDP measures spending on output using current-year prices. The problem is a rise in nominal GDP could be from more production, higher prices, or both, so it’s not that useful for measuring actual production on its own.
- Real GDP measures how much is actually being produced, using prices from a fixed base year. By holding prices constant, any rise in real GDP has to come from an increase in actual output.
In the base year, real GDP equals nominal GDP. Looking at real data over time can reveal that while nominal GDP rises every year, real GDP might be flat, showing that the nominal growth was really just an illusion created by rising prices.
The base-year method has a flaw. Goods whose prices fall over time (like computers) keep getting weighted by their old, higher base-year prices, which makes real GDP growth look bigger than it really is. So the official US numbers (from the Bureau of Economic Analysis) use a chain-weighted method that updates the prices every year. On the AP exam, you’ll use the base-year method.
The GDP Deflator
In the base year, the deflator is always 100, since nominal and real GDP are equal. You can also find real GDP by dividing nominal GDP by the price level and multiplying by 100.
Example: an economy only makes pizzas and haircuts. Year 1 is the base year.
Year | Pizzas | Pizza price | Haircuts | Haircut price |
Year 1 (base) | 100 | $10 | 50 | $20 |
Year 2 | 120 | $12 | 50 | $24 |
- Nominal GDP in Year 1 = (100 × $10) + (50 × $20) = $2,000. This is also real GDP, since Year 1 is the base year.
- Nominal GDP in Year 2 (Year 2 prices) = (120 × $12) + (50 × $24) = $2,640
- Real GDP in Year 2 (base-year prices) = (120 × $10) + (50 × $20) = $2,200
- GDP deflator in Year 2 = ($2,640 ÷ $2,200) × 100 = 120
Nominal GDP grew 32%, but real GDP only grew 10% (from $2,000 to $2,200). The rest came from prices rising 20%, which the deflator shows (120 vs. 100). You can also go the other way: Year 2 real GDP = ($2,640 ÷ 120) × 100 = $2,200.
Deflator vs. CPI: both measure inflation, but the GDP deflator avoids the substitution bias that hurts the CPI. However, the deflator also includes government and investment spending, so it’s not as good a reflection of everyday cost of living.
Takeaway
Nominal GDP gets distorted by inflation since it uses current prices, making it unreliable for tracking real growth. Real GDP, using constant base-year prices, controls for inflation and accurately shows changes in output. The GDP deflator uses the ratio between the two to measure price changes.