ECON102: Principles of Macroeconomics (2024.A.01)

When examining economic statistics, there is a crucial distinction worth emphasizing. The distinction is between nominal and real measurements, which refer to whether inflation distorts a given statistic. Looking at economic statistics without considering inflation is like looking through a pair of binoculars and trying to guess how close something is: unless you know how strong the lenses are, you cannot guess the distance very accurately. Similarly, if you do not know the inflation rate, it is difficult to figure out if a rise in GDP is due mainly to a rise in the overall level of prices or to a rise in the quantities of goods produced. The nominal value of any economic statistic means that we measure the statistic in terms of actual prices that exist at the time. The real value refers to the same statistic after it has been adjusted for inflation. Generally, it is the real value that is more important.

Converting Nominal to Real GDP

Table 6.5 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. Figure 6.7 also reflects this data in a graph.

Table 6.5 U.S. Nominal GDP and the GDP Deflator

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 more than 38 over this time (that is, GDP of $20.9 trillion in 2020 divided by GDP of $543 billion in 1960 = 38). This conclusion would be highly misleading. Recall that we define nominal GDP 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 order to see how much production has actually increased, we need to extract the effects of higher prices on nominal GDP. We can easily accomplish this using the GDP deflator.

The GDP deflator is a price index measuring the average prices of all final goods and services included in the economy. We explore price indices in detail and how we compute them in Inflation, but this definition will do in the context of this chapter. Table 6.5 provides the GDP deflator data and Figure 6.8 shows it graphically.

Figure 6.8 U.S. GDP Deflator, 1960–2020 Much like nominal GDP, the GDP deflator has risen exponentially from 1960 through 2010.

Figure 6.8 shows that the price level has risen dramatically since 1960. The price level in 2020 was seven times higher than in 1960 (the deflator for 2020 was 113 versus a level of 17 in 1960). Clearly, much of the growth in nominal GDP was due to inflation, not an actual change in the quantity of goods and services produced, in other words, not in real GDP. Recall that nominal GDP can rise for two reasons: an increase in output and/or an increase in prices. What is needed is to extract the increase in prices from nominal GDP so as to measure only changes in output. After all, the dollars used to measure nominal GDP in 1960 are worth more than the inflated dollars of 2020 - and the price index tells exactly how much more. This adjustment is easy to do if you understand that nominal measurements are in value terms, where

Value = Price × Quantity
or
Nominal GDP = GDP Deflator × Real GDP

Let's look at an example at the micro level. Suppose the t-shirt company Coolshirts sells ten t-shirts at a price of $9 each.

Coolshirt's nominal revenue from sale = Price × Quantity
= $9 × 10
= $90

Then,

Coolshirt's real income = Nominal revenue / Price

= $90/9

=$10

In other words, when we compute "real" measurements, we are trying to obtain actual quantities, in this case, ten t-shirts.

With GDP, it is just a tiny bit more complicated. We start with the same formula as above:

For reasons that we will explain in more detail below, mathematically, a price index is a two-digit decimal number like 1.00 or 0.85 or 1.25. Because some people have trouble working with decimals, when the price index is published, it has traditionally been multiplied by 100 to get integer numbers like 100, 85, or 125. What this means is that when we "deflate" nominal figures to get real figures (by dividing the nominal by the price index). We also need to remember to divide the published price index by 100 to make the math work. Thus, the formula becomes:

$\text{Real GDP }= \dfrac{\text{Nominal GDP }}{\text{Price Index} / 100}$

Now read the following Work It Out feature for more practice calculating real GDP.

Figure 6.9 shows the U.S. nominal and real GDP since 1960. Because 2005 is the base year, the nominal and real values are exactly the same in that year. However, over time, the rise in nominal GDP looks much larger than the rise in real GDP (that is, the nominal GDP line rises more steeply than the real GDP line) because the presence of inflation, especially in the 1970s, exaggerates the rise in nominal GDP.

Figure 6.9 U.S. Nominal and Real GDP, 1960–2020 The red line measures U.S. GDP in nominal dollars. The black line measures U.S. GDP in real dollars, where all dollar values are converted to 2012 dollars. Since we express real GDP in 2012 dollars, the two lines cross in 2012. However, real GDP will appear higher than nominal GDP in the years before 2012 because dollars were worth less in 2012 than in previous years. Conversely, real GDP will appear lower in the years after 2012 because dollars were worth more in 2012 than in later years.

Let's return to the question that we posed originally: How much did GDP increase in real terms? What was the real GDP growth rate from 1960 to 2020? To find the real growth rate, we apply the formula for percentage change:

$\begin{aligned} & \frac{2020 \text { real GDP }-1960 \text { real GDP }}{1960 \text { real GDP }} \times 100=\% \text { change } \\ & \frac{18,392.3-3,267.5}{3,267.5} \times 100=463 \% \\ & \end{aligned}$

In other words, the U.S. economy has increased real production of goods and services by nearly a factor of five since 1960. Of course, that understates the material improvement since it fails to capture improvements in the quality of products and the invention of new products.

There is a quicker way to answer this question approximately, using another math trick. Because:

Nominal = Price × Quantity

% change in Nominal = % change in Price + % change in Quantity

OR 

% change in Quantity =  % change in Nominal – % change in Price

Therefore, real GDP growth rate (% change in quantity) equals the growth rate in nominal GDP (% change in value) minus the inflation rate (% change in price).

Note that using this equation provides an approximation for small changes in the levels. For more accurate measures, one should use the first formula.

Source: Rice University, https://openstax.org/books/principles-macroeconomics-3e/pages/6-2-adjusting-nominal-values-to-real-values
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