Lesson Overview

Even GDP needs to keep it real. When we calculate GDP using today’s prices, we are creating a measure called nominal GDP. However, prices can change even if output doesn’t change. Because of that, our measure of output might get distorted by something like inflation.
We account for this using real GDP, which is a measure of GDP that has been adjusted for the price level. In this way, real GDP is a truer measure of output in an economy. There are two approaches to adjusting nominal GDP to get real GDP: 1) using the same prices every year or 2) using the GDP deflator.

Key Terms

nominal GDPthe market value of the final production of goods and services within a country in a given period using that year’s prices (also called “current prices”)
real GDPnominal GDP adjusted for changes in the price level, using prices from a base year (constant prices) instead of “current prices” used in nominal GDP; real GDP adjusts the level of output for any price changes that may have occurred over time
GDP deflatora price index used to adjust nominal GDP to find real GDP; the GDP deflator measures the average prices of all finished goods and services produced within a nation’s borders over time.
base yearthe year used for comparison in the determination of price changes using the GDP deflator price index; the deflator in a base year is always equal to =100=100.
current pricesthe prices at which goods are sold in a nation in a particular year; current prices are used when calculating nominal GDP.
constant pricesthe prices from a base year that are used to calculate real GDP in other years; this allows for a more accurate measure of how a country’s actual output changes over time, because using constant prices cancels out any changes in the price level between years.

Key takeaways

Definitions of nominal v. real GDP

Nominal GDP is a measure of how much is spent on output. For example, in Canada during 2015, CAN $1,994.9 billion\text{CAN }\$1,994.9\text{ billion} was spent on the goods and services produced in Canada. Nominal GDP measures aggregate output (meaning the value of all of the final goods and services produced) using current prices. In other words, these figures reflect the amount spent on Canada’s output in the country’s prices in 2015.

Real GDP weighs output using prices from a base year

Real GDP is a measure of how much is actually produced. Real GDP measures aggregate output using constant prices, thus removing the effect of changes in the overall price level. For example, in 2015 the value of Canada’s output expressed in constant 2010 prices was CAN $1,857 bilion\text{CAN }\$1,857\text{ bilion}.
Here’s another way to think about Real GDP: if we add up all of the output that was produced in Canada during 2015 by using the prices that these goods sold for in 2010, the value of GDP in Canada is $1,857 billion\$1,857\text{ billion}. But if we add up all of the output that was produced in Canada during 2015, using the prices that they sold for in 2015, the value of GDP in Canada is $1,995 billion\$1,995\text{ billion}. This means prices must have increased between 2010 and 2015.
However, there is a slight problem with the method above. Calculating real GDP by weighting final goods and services by their prices in a base year can lead to an overstatement of real GDP growth because the prices of some goods decrease over time. Therefore, this method overstates growth in real GDP because it makes it seem like goods make up a bigger share of spending than they really do.
In other words, if the price of a good is going down (if it has gotten cheaper to produce), then using a price from long ago when it was really expensive would make it seem like a bigger deal in terms of GDP than it really is.
For example, if between 2010 and 2015 the average price of a Canadian-made hockey stick fell from $100\$100 to $50\$50, and Canada produces 1m1m hockey sticks in 2010 and only 0.8m0.8m in 2015, the real output of hockey sticks would have appeared to have increased (since the base year price was actually higher than the current year price). In this way, weighting output using base year prices can cause a country’s GDP can be overstated.

The GDP deflator and real GDP

Another method of calculating real GDP involves converting nominal GDP to real GDP by using the GDP deflator, which tracks price changes of a nation’s output over time. Canada’s GDP deflator for its base year of 2010 was 100100 since this is the year against which prices are compared. By 2015 the deflator had increased to 107.4107.4, indicating that the average prices of Canada’s output had increased by 7.4%7.4\%.
By expressing 2015’s output in 2015 prices, therefore, Canada’s output would appear to have increased by more than it actually did. Canada’s nominal GDP, which has been “inflated” by higher prices, can be “deflated” by dividing the country’s nominal GDP of CAN $1,994 billion\text{CAN }\$1,994 \text{ billion} by the deflator expressed in hundredths.
Canada’s real GDP can be approximated using this method.
Real GDP=$1,994 billion1.074=$1,857\begin{aligned} \text{Real GDP}&=\dfrac{\$1,994\text{ billion}}{1.074} \\\\ &= \$1,857\end{aligned}
Canada's real GDP can be calculated by weighting final goods and services by their prices in a base year or by dividing nominal GDP by the GDP deflator price index in hundredths. Either method is considered valid, but the deflator method is more likely to account for price changes of particular goods produced by a nation between a base year and the current year.
SOURCE: Organization for Economic Co-operation and Development https://stats.oecd.org (accessed February 1, 2018).

Key Equations

Real GDP=Nominal GDPGDP deflator in hundredthsNominal GDP=Real GDP×GDP deflator (in hundredths)\begin{aligned} \text{Real GDP} &=\dfrac{\text{Nominal GDP}}{\text{GDP deflator in hundredths}}\\\\\text{Nominal GDP}&=\text{Real GDP}\times\text{GDP deflator (in hundredths)}\end{aligned}

Common misperceptions:

  • An increase in GDP does not necessarily mean a nation has produced more output; it must be specified whether the GDP in question is nominal or real. An increase in nominal GDP may just mean prices have increased, while an increase in real GDP definitely means output increased.
  • The GDP deflator is a price index, which means it tracks the average prices of goods and services produced across all sectors of a nation's economy over time. With this index, changes in the average price level (inflation or deflation) can be calculated between years. However, this is not the most commonly used price index for tracking inflation and deflation. The consumer price index (CPI) is the most commonly used price index, which you'll learn more about later in this course.

DIscussion questions

  • Why could calculating GDP each year using current prices overstate or understate changes in actual output year to year?
Explanation: If current prices are higher than they were in previous years, then it will be inflated by higher prices and a country’s nominal GDP will overstate the actual change in output.On the other hand, if current prices are lower than in previous years, the value will be deflated by lower prices and nominal GDP will understate the actual change in output.
  • Why do increases in real GDP indicate an improvement in living standards, whereas increases in nominal GDP might not?
Explanation: Measuring real GDP holds prices constant or adjusts the value of the nation’s output to higher or lower prices that may have prevailed from earlier years (using the GDP deflator price index). In this way the real GDP represents the actual amount of the nation’s output; which if it has increased indicates that the typical person now has more goods and services available, a result generally believed to lead to higher living standards.
  • The table below shows the output and the prices of Switzerland in 2017 and in 2018.
Goods produced2017 price2017 quantity2018 price2018 quantity
a) Calculate Switzerland’s nominal GDP in (i) 2017 and (ii)2018.
b) Calculate Switzerland’s real GDP in 2018 using constant 2017 prices.
c) Calculate the GDP deflator price index for 2018. How much did the average price of goods produced in Switzerland change between 2017 and 2018?
(a)(i) 2017 nominal GDP=($2×400)+($6×200)+($20×80)=($800)+($1200)+($1,600)=$3,600(ii) 2018 nominal GDP=($2.20×400)+($8×250)+($25×80)=($880)+($2,000)+($2,500)=$5,380(b) real GDP 2018=($2×400)+($6×250)+($20×100)=($800)+($1500)+($2000)=$4,300(c) GDP deflator for 2018 =nominal GDP2018real GDP2018×100=$5,380$4,300×100=1.25×100=125(d) Increase in GDP deflator=125100100×100=125%\begin{aligned}\text{(a)(i) 2017 nominal GDP}&=(\$2 \times 400) +(\$6 \times 200) + (\$20 \times 80)\\ \\ &=(\$800) +(\$1200)+(\$1{,}600)\\ \\ &=\$3{,}600\\ \\ \text{(ii) 2018 nominal GDP} &=(\$2.20 \times 400) +(\$8 \times 250) + (\$25 \times 80)\\ \\ &=(\$880) +(\$2{,}000)+(\$2{,}500)\\ \\ &=\$5{,}380\\ \\ \text{(b) real GDP 2018}&=(\$2 \times 400) + (\$6 \times 250) + (\$20 \times 100)\\ \\ &=(\$800) + (\$1500)+(\$2000)\\ &=\$4{,}300\\ \\ \text{(c) GDP deflator for 2018 }&=\dfrac{\text{nominal GDP}_{2018}}{\text{real GDP}_{2018}}\times 100\\\\ &=\dfrac{\$5{,}380}{\$4{,}300}\times 100\\ \\ &=1.25 \times 100 \\ \\ &=125\\ \\ \text{(d) Increase in GDP deflator}&=\dfrac{125-100}{100} \times 100%\\ \\ &=125\% \end{aligned} The average price of goods increase by 25%25\%.