22 Real GDP vs Nominal GDP
Comparing Real GDP to Nominal GDP
How much of the increase in GDP is the result of inflation and how much is an increase in real output? To answer this question, we need to take a closer look at how economists calculate Real GDP (RGDP), and how it differs from Nominal GDP (NGDP). The market valueof production and hence GDP can increase either because the production of goods and services are higher ( quantities ) or because theprices of goods and services are higher. Because the focus in measuring GDP is to find out whether a country’s ability to produce higher quantities of goods and services has changed, when calculating RGDP we try to remove the effect of price changes by using prices of a reference year, called a base year. This way, we keep prices fixed (unchanged) at the level they were in the base year whenever we calculate RGDP. (1)
Calculating Real GDP
- Nominal GDP is the value of the final goods and services produced in a given year expressed in terms of the prices in that same year.
- To calculate Nominal GDP , we use current year prices and multiply them by current year quantities for all the goods and services produced in an economy. For the purposes of demonstrating the method, we will work with hypothetical economies consisting of no more than two or three goods and services. You can imagine that the same method applies if a lot more goods and services were included.
- Real GDP allows the quantities of production to be compared across time. Real GDP is the value of final goods and services produced in a given year expressed in terms of the prices in a base year.
- To calculate Real GDP, we use base year prices and multiply them by current year quantities for all the goods and services produced in an economy. For the purposes of demonstrating the method, we will work with hypothetical economies consisting of no more than two or three goods and services. You can imagine that the same method applies if a lot more goods and services were included.
- In the base year, RGDP is calculated using prices of the current year (base year = current year), therefore RGDP always equals NGDP in the base year. (1)
Example:
Table 3 contains summarized information for a hypothetical economy’s total production and corresponding prices (you can think of them as average prices) of all the final goods and services it produced in 2015 and 2016. The base year is 2015.
Table 3
Year 2015
| Item | Quantity | Price |
|---|---|---|
| Goods | 120 | $50 |
| Services | 100 | $65 |
Year 2016
| Item | Quantity | Price |
|---|---|---|
| Goods | 130 | $55 |
| Services | 110 | $70 |
In 2015, nominal GDP = 120 x $50 + 100 x $65 = $6,000 + $6,500 = $12,500
In 2016, nominal GDP = 130 x $55 + 110 x $70 = $7,150 + $7,700 = $14,850
Nominal GDP has increased significantly, but what how much has real GDP changed between these years? To calculate RGDP, we first need to decide which one will be the base year. Use 2015 as the base year. Then, real GDP in 2015 equals nominal GDP in 2015 (always the case for the base year) = $12,500.
To calculate real GDP in 2016, we need to use the 2016 quantities and the 2015 prices, since 2015 is the base year.
RGDP in 2016 = 130 x $50 + 110 x $65 = $6,500 + $7,150 = $13,650.
Notice that RGDP has increased less than NGDP from 2015 to 2016. This will always be the case if both prices and quantities increase from year to year. (1)