Unit 2 · Topic 2.6

Real v. Nominal GDP

Nominal GDP values output at current prices; real GDP values it at base-year prices, so only real GDP changes with production.

Practice 1: Principles and ModelsPractice 2: InterpretationPractice 3: Manipulation

Part 1 · Hook

Why this matters

A headline says GDP hit a record, up 6% in a year. Are people producing 6% more? Not if prices rose 7%: then the economy actually produced less. Nominal GDP mixes how much is made with what it sells for. Taking out the price changes gives real GDP, the number that tells you whether output really grew.

Part 2 · Before you start

What this builds on

Part 3 · Prerequisite check

Quick check before you start

1. A price index is 125. What does that mean?

Prices are 25% above the base year
Prices rose 125%
The basket costs 125 dollars
Inflation this year is 125%

Show the answer

The base year is 100, so 125 is 25% higher.

Correct: Prices are 25% above the base year:
Prices rose 125%:
The basket costs 125 dollars:
Inflation this year is 125%:

2. A nominal wage of $$30$ with a CPI of 120 is a real wage of

$25
$36
$0.25
$30

Show the answer

$\frac{30}{120} \times 100 = 25$ : divide by the index and multiply by 100.

Correct: $25:
$36:
$0.25:
$30:

3. GDP per capita is

GDP divided by population
GDP times population
GDP minus imports
GDP divided by the labor force

Show the answer

Output per person: GDP divided by population.

Correct: GDP divided by population:
GDP times population:
GDP minus imports:
GDP divided by the labor force:

Part 4 · See it

See it first

Line chart of invented data, Years 1 to 5, base Year 3. Real GDP rises from 900 to 1,100 billion dollars. Nominal GDP rises from 810 to 1,210. The lines cross in Year 3: before it nominal GDP is below real GDP because prices were lower than in the base year, and after it nominal GDP is above real GDP. — Nominal GDP is below real GDP before the base year and above it after, because prices were lower then and higher later; the two are equal in the base year. LevlPrep original diagram.

Part 5 · Step by step

How it works, step by step

Nominal GDP values each year's output at that year's pricesit can rise because prices rose, because output rose, or both
Real GDP values each year's output at base-year pricesit changes only when quantities produced change
Divide nominal GDP by real GDP and multiply by 100the GDP deflator, a price index for everything produced
Divide nominal GDP by the deflator and multiply by 100real GDP, whose percent change is the growth rate of output

Part 6 · Key ideas

Key ideas

Nominal GDP uses current prices; real GDP uses base-year prices, so it measures output.
GDP deflator $= \frac{\text{nominal GDP}}{\text{real GDP}} \times 100$ ; real GDP $= \frac{\text{nominal GDP}}{\text{deflator}} \times 100$ . Divide by the deflator, never multiply.
The deflator is an index (base year 100), not a percent or dollars. Below 100 means prices were lower than in the base year.
Growth rate of real GDP $= \frac{\text{new} - \text{old}}{\text{old}} \times 100$ , using real values. Real GDP per capita measures living standards.

Part 7 · Misconception

A common mistake

The wrong idea: To get real GDP, multiply nominal GDP by the deflator, and a rise in nominal GDP means output grew.

What actually happens: Divide nominal GDP by the deflator and multiply by 100. Nominal GDP can rise from higher prices alone, so only real GDP shows whether output grew.

Part 8 · Check yourself

Check yourself

Exam-style questions. Anything you miss goes into your review queue.

Data

A two-good economy over two years

Country X produces only apples and bread; Year 1 is the base year (invented data for practice)
Year	Apples (quantity)	Price of apples	Bread (loaves)	Price of bread
1	100	$2.00	50	$4.00
2	120	$2.50	50	$5.00

1. What is nominal GDP in Year 2, in dollars?

Type a number. A four-function calculator is allowed, as on the exam.

Show the answer

Nominal GDP uses each year's own prices: $120 \times 2.50 + 50 \times 5$ $= 300 + 250$ $= 550$ dollars.

Answer: 550

2. What is real GDP in Year 2, measured in Year 1 prices, in dollars?

Type a number. A four-function calculator is allowed, as on the exam.

Show the answer

Real GDP values this year's quantities at base-year prices: $120 \times 2 + 50 \times 4$ $= 240 + 200$ $= 440$ dollars.

Answer: 440

3. What is the GDP deflator in Year 2?

Type a number. A four-function calculator is allowed, as on the exam.

Show the answer

Deflator $= \frac{\text{nominal GDP}}{\text{real GDP}} \times 100$ $= \frac{550}{440} \times 100$ $= 125$ . Prices of the goods in GDP are 25% above the base year.

Answer: 125

Data

Nominal GDP and the GDP deflator in Halvet

Halvet, Year 1 is the base year (nominal GDP in billions of dollars; invented data for practice)
Year	Nominal GDP	GDP deflator
1	800	100
2	900	120
3	990	110

4. What is Halvet's real GDP in Year 2, in billions of dollars?

Type a number. A four-function calculator is allowed, as on the exam.

Show the answer

Real GDP $= \frac{\text{nominal GDP}}{\text{deflator}} \times 100$ $= \frac{900}{120} \times 100$ $= 750$ billion dollars.

Answer: 750

Scenario

A headline about record GDP

A news site in Country Q reports: "GDP hits a record! Nominal GDP rose 6% this year, the biggest jump in a decade." Further down, the article notes that the GDP deflator rose 7% over the same year and that the population grew 1%.

5. Based on the full article, what happened to Country Q's real GDP this year?

It rose by about 13%
It rose by about 5%, after population growth
It fell by about 1%
It rose by about 6%, a record

Show the answer

Nominal GDP growth is about real growth plus inflation, so real growth is about nominal growth minus the change in the deflator.

It rose by about 13%: A rising deflator is subtracted from nominal growth, not added.
It rose by about 5%, after population growth: Population growth matters for output per person, but the first step is removing price changes.
Correct: It fell by about 1%: Right: real growth is about nominal growth minus the rise in the deflator: $6 - 7 = -1\%$ .
It rose by about 6%, a record: Six percent is the nominal rise, which includes higher prices.

6. In a year before the base year, a country's nominal GDP is 400 billion dollars and its GDP deflator is 80. What is its real GDP, in billions of dollars?

Type a number. A four-function calculator is allowed, as on the exam.

Show the answer

$\frac{400}{80} \times 100 = 500$ billion. Prices were lower than in the base year, so real GDP (at base-year prices) is larger than nominal GDP.

Answer: 500

7. Why do economists use real GDP rather than nominal GDP to measure changes in output over time?

Real GDP is measured in current prices
Real GDP is larger than nominal GDP in each year
Real GDP holds prices fixed, so only quantities move it
Real GDP includes used goods and transfers

Show the answer

Valuing every year's output at the same base-year prices means changes in real GDP reflect changes in production.

Real GDP is measured in current prices: That is nominal GDP; real GDP uses base-year prices.
Real GDP is larger than nominal GDP in each year: Real GDP is smaller than nominal after the base year when prices have risen.
Correct: Real GDP holds prices fixed, so only quantities move it: Right: nominal GDP can rise from higher prices alone; real GDP removes that.
Real GDP includes used goods and transfers: Real and nominal GDP count the same goods; only the prices used differ.

Part 9 · Summary

Summary

Nominal GDP values output at current prices; real GDP values it at base-year prices, so only real GDP changes with production. The GDP deflator is nominal GDP divided by real GDP times 100, and real GDP is nominal GDP divided by the deflator times 100. The growth rate of real GDP is its percent change, and real GDP per capita measures living standards.

Part 10 · Up next

What comes next

Part 11 · Connections

Connections

Question set for this topic