82 Comparing Nominal and Real GDP

Comparing Nominal and Real GDP

In the last section, we introduced the difference between real measurements and nominal measurements of the same economic statistic. On this page, we explore this challenging, but important, distinction in more depth.

Table 1 shows U.S. GDP at five-year intervals since 1960 in nominal dollars; that is, GDP measured using the actual market prices prevailing in each stated year. This data is also reflected in the graph shown in Figure 1.

Table 1. U.S. Nominal GDP (1960-2010)
Year	Nominal GDP (billions of dollars)
1960	543.3
1965	743.7
1970	1,075.9
1975	1,688.9
1980	2,862.5
1985	4,346.7
1990	5,979.6
1995	7,664.0
2000	10,289.7
2005	13,095.4
2010	14,958.3
Source: www.bea.gov, National Accounts

If an unwary analyst compared nominal GDP in 1960 to nominal GDP in 2010, it might appear that national output had risen by a factor of nearly twenty-seven over this time. This conclusion comes from the simple growth rate formula (or percentage change formula):

(Final GDP – Initial GDP) / Initial GDP = Growth of Nominal GDP

or

($14,958 – $543) / $543 = 2653%

This conclusion, though, would be highly misleading. Recall that nominal GDP is defined as the quantity of every final good or service produced multiplied by the price at which it was sold, summed up for all goods and services. In other words, nominal GDP is the value of output produced:

[latex]\text{Nominal Value of Output}=\text{Price}\times\text{Quantity of Output}[/latex]

We’ll call this the Real-to-Nominal formula.

Nominal output is the value of what’s produced, while real output is the quantity of what’s produced (in the previous case, pounds of apples). If we produce more apples we can say our real output has increased.  

Now suppose our apply economy from above now produces two goods: apples and xylophones.

It’s easy to compute how much nominal GDP has increased. In year one, the value of apples produced was $1000, and the value of xylophones produced was $1000, so nominal GDP (assuming these are the only two goods in the economy) was $2000. Similarly in year 2, the value of apples produced was $1200, and the value of xylophones produced was $1800, so nominal GDP was $3000. Thus, nominal GDP increased by $1000 (the increase)/$2000 (the nominal GDP in year one)= 50%.

But what has happened to real GDP? Real output of apples has increased from 2000 lbs to 2182 lbs. Real output of xylophones has increased from 100 to 150. How much has real output increased? Can we say that Real GDP has increased from 2100 to 2332 items? The answer is no, because it doesn’t make sense to add apples & xylophones together, since they are used for different purposes and have different values. What we need is a common denominator, which would allow us to compare apples and xylophones. The common denominator economists use for this purpose is price, since price reflects the value of what something is worth.

Remember that we’re using price here as a common denominator to enable us to “add” quantities of apples and xylophones together. But which year’s prices should we use? The answer is arbitrary.  We can choose the prices from any year as long as we use them with each year’s quantities. Suppose we choose the set of prices from year one. We use those prices, both in year one and in year two. Thus, real GDP in year one is

[latex]\text{real GDP}_\text{year 1}=\text{Price of apples}_\text{year 1}\times\text{Quantity of apples}_\text{year 1}+\text{Price of xylophones}_\text{year 1}\times\text{Quantity of xylophones}_\text{year 1}[/latex]