Introducing Concepts - Nominal GDP and Real GDP - Online Tutor, Practice Problems & Exam Prep

Gross Domestic Product (GDP) measures the value of goods and services produced by a country in a specific year. It can be categorized into nominal GDP, which uses current year prices, and real GDP, which uses base year prices to account for inflation. For example, if a carpenter produces 100 cabinets priced at $1,000 in 2017 and $2,000 in 2018, nominal GDP would show an increase due to price changes, while real GDP would remain constant, reflecting stable production levels. This distinction is crucial for understanding economic performance and trends.

Nominal GDP

Alright. Let's discuss on a high level one of the more important calculations you're going to make in this class, it's about gross domestic product. Let's check it out. So gross domestic product, it measures this is the definition, the value of goods and services produced by a country in a specific year. So gross domestic product, it's the level of production in an economy, right? And we generally measure it year by year. So gross domestic product, you're going to see it all the time, the acronym GDP. Okay? And you're going to get really familiar with it throughout this class and we're going to go to a lot more detail in other videos about GDP. Okay? So, GDP is our gross domestic product. And when we talk about it in this class, we usually talk about two measures of GDP, the nominal GDP and real GDP. That's what we're going to discuss in this video. So, what we can say is that if GDP in the economy is greater in one year than the other, then we could say that the economy is expanding, okay? So that's a good thing for the economy, right? If the GDP is greater in year two than in year one, well, we're expanding. The other way around, if the GDP is decreasing, this is a signal that we're possibly in a recession, right? As we see production start to decrease in an economy. Cool? So let's start here with nominal GDP and then we'll talk about real GDP in the next video. So, nominal GDP, it's a measure of GDP using current year prices. So we are using the current year prices when we calculate nominal GDP, and we'll see why this is important when we compare it to real GDP. So let's do this example here. A carpenter builds 100 cabinets. The prices in 2017 are $1,000 per cabinet. In 2018, the price rises to $2,000 per cabinet. Okay? So let's imagine that this is the only thing in the economy. This is the only production that there is in the whole economy. It's a very simple carpenter town where this is all that happens, right? So if this is all of the production, well, GDP would be the production in this economy would be the 100 cabinets. So in 2017, we could calculate GDP as the 100 cabinets that got produced times the price of those cabinets, $1,000, GDP=100×1000=100000 and that would tell us that these cabinets are worth, $100,000 and that is the production in that economy in 2017. Right? So in 2017, GDP would be $100,000 because that is what that economy produced. So you can imagine in a more complicated situation like an actual economy like the United States, this is quite a hefty calculation. Everything that gets produced in the economy, how do we even get that kind of detail? Well, we'll get into that in another lesson, but for now, let's keep it pretty simple. Okay? So this is how we would calculate the GDP. We would find everything that was produced, the 100 cabinets and what were they worth? A $1,000. So check it out. In 2018, how is this calculation any different? Well, they still produced 100 cabinets, let's say. Right? In 2018, there's still 100 cabinets that get produced. So they produced 100 cabinets in 2017, 100 cabinets in 2018. Right? But now in 2018, the price is $2,000 per cabinet. So this leads GDP, nominal GDP, to be GDP=100×2000=200000 Now, did the economy really produce more? This is kind of a trick with nominal GDP since we're using the current year prices. It might seem like, hey, in 2018, there was so much more production. GDP doubled in 2018, the economy must be doing great, right? But is that really the true picture here? In 2017, they built 100 cabinets. In 2018, they built 100 cabinets. So really, did production really increase? Maybe just the dollar value of that production increased. So what we do is we use a measure called real GDP. Let's pause real quick and let's talk about real GDP in the next video.

Real GDP

So we saw that nominal GDP could pose some problems, right? Where we had the same level of production, 100 cabinets in each year, but since the price increased in 2018 compared to 2017, GDP increased. Now what we do is we use this calculation called real GDP and what it does is, instead of using current year prices, we are going to use what we call base year prices. And the base year is going to be held constant. So we're going to be using the same prices every year, okay? So when we do this measure, we're going to say this year is the base year, whatever year that might be. And it doesn't even have to be one of the years you're calculating. The base year in this situation doesn't have to be 2017 or 2018. It could be the year 1983. It doesn't matter what year you choose, it just has to stay constant for the calculation.

Okay? So you're using the same prices in every year, that way we're more focused on the quantity of production rather than the price of the goods changing, okay? So let's check out our example here. A carpenter builds 100 cabinets, the prices in 2017 are $1,000 per cabinet. In 2018, the prices rise to $2,000. So it doesn't say it here, but let's assume 2017 is the base year. Okay? So let's write that in there. Assume that 2017 is the base year and generally, when you get a problem like this on a test, they're going to have to tell you which year is the base year. If they don't say anything, you can just assume that the oldest year is the base year.

Okay? So let's go ahead and do this example. Let's do our real GDP here. In 2017, what is our real GDP? Well, we produced 100 cabinets and what were those prices in the base year? The base year was 2017 and the price was $1,000. So that leads us to our same conclusion of $100,000. Okay? Notice that our real GDP and our nominal GDP in the base year when we have 2017 as the base year, they are the same, right? And that should always hold true because the base year price is the same price that we use for both calculations, nominal and real GDP. However, let's do 2018's real GDP. How are we going to do that calculation?

Now in 2018, we still had 100 cabinets produced, but we have to use the base year price of $1,000, and that leads us to have $100,000 for the real GDP in 2018 as well. So notice how now we can compare 2017 and 2018 GDP a little better, right? It doesn't take into account that inflation of prices. Right? The price doubled, so our GDP had doubled. But now this has more of a focus on the level of production. Where both years we produced 100 cabinets, so we should have a relative measure that shows that they had the same level of production. Okay? So we got $100,000 for GDP, for real GDP in 2018 and notice that previously, when we calculated nominal GDP, we had gotten $200,000, right? Because we had used the nominal price in 2018, which was $2,000. Cool? So that's the difference between real GDP and nominal GDP is which price we use, okay? So real GDP is a good measure that keeps the prices constant where nominal GDP is using more current numbers, okay? So there's pros and cons to both, but generally, we're going to be focused on real GDP when we do these calculations.

Alright. Let's do a quick pause and we'll do a practice question related to nominal GDP and real GDP.

Simpletown produces Apples and Robots. In Year 1, Simpletown harvested 1,000 apples and built 50 robots. During Year 2, Simpletown had identical production to Year 1. However, during Year 2, prices rose by 50%. Based on this information, which of the following is true?

• A. Simpletown's real GDP was higher in Year 2
• B. Simpletown's real GDP was lower in Year 2
• C. Simpletown's nominal GDP was higher in Year 1
• D. Simpletown's nominal GDP was lower in Year 1
• E. Both (a) and (d) are true

Here’s what students ask on this topic:

What is the difference between nominal GDP and real GDP?

Nominal GDP measures the value of goods and services produced in a country using current year prices. This means it does not account for inflation or deflation. Real GDP, on the other hand, uses base year prices to measure the value of goods and services, which allows it to account for changes in price levels over time. This distinction helps in understanding whether changes in GDP are due to actual changes in production or merely changes in price levels.

Why is real GDP considered a better measure of economic performance than nominal GDP?

Real GDP is considered a better measure of economic performance because it accounts for inflation, providing a more accurate reflection of an economy's true growth. By using base year prices, real GDP isolates changes in production levels from changes in price levels, allowing for a clearer comparison of economic output over different years. This helps in understanding whether an economy is genuinely growing or if apparent growth is just due to rising prices.

How do you calculate nominal GDP?

Nominal GDP is calculated by multiplying the quantity of goods and services produced in a given year by their current year prices. For example, if a carpenter produces 100 cabinets priced at $1,000 each in 2017, the nominal GDP for that year would be:

$100\times 1000=100000$

This calculation includes the effects of price changes over time.

How do you calculate real GDP?

Real GDP is calculated by multiplying the quantity of goods and services produced in a given year by the prices from a base year. For example, if a carpenter produces 100 cabinets in 2018, and the base year is 2017 with a price of $1,000 per cabinet, the real GDP for 2018 would be:

$100\times 1000=100000$

This calculation removes the effects of inflation, providing a clearer picture of actual production changes.

What are the limitations of using nominal GDP to measure economic growth?

The main limitation of using nominal GDP to measure economic growth is that it does not account for inflation or deflation. This means that increases in nominal GDP could be due to rising prices rather than an actual increase in the quantity of goods and services produced. As a result, nominal GDP can give a misleading picture of an economy's true growth and performance over time.