1. Section 3A 11
GDP Real vs Nominal
Module

2. 20.3 NOMINAL GDP VERSUS REAL GDP
Calculating Real GDP
Real GDP
The value of the final goods and services produced in a given year expressed in the prices of the base year.
Nominal GDP
The value of the final goods and services produced in a given year expressed in the prices of that same year.
The method of calculating real GDP changed in recent years, we describe the two methods.

3. 20.3 NOMINAL GDP VERSUS REAL GDP
Traditional Method of Calculating Real GDP
We’ll calculate real GDP in an economy that produces only apples and oranges. The current year is 2006, and the base year is 2000.
Because 2000 is the base year, real GDP and nominal GDP are the same in 2000.
Let’s use the traditional method to calculate real GDP in 2000 and 2006.

4. 20.3 NOMINAL GDP VERSUS REAL GDP
GDP Data for 2000:
To calculate real GDP in 2000, sum the values of apples and oranges produced in 2000 using prices in 2000.
Value of apples = 60 apples x $0.50 = $30
Value of oranges = 80 oranges x $0.25 = $20
Nominal GDP in 2000 = $30 + $20 = $50

5. 20.3 NOMINAL GDP VERSUS REAL GDP
GDP Data for 2006:
To calculate real GDP in 2006, sum the values of apples and oranges produced in 2006 using prices in 2000.
Value of apples = 160 apples x $0.50 = $80
Value of oranges = 220 oranges x $0.25 = $55
Real GDP in 2006 = $80 + $55 = $135

6. 20.3 NOMINAL GDP VERSUS REAL GDP
Chained-Dollar Method of Calculating Real GDP
The chained-dollar method does not use the base-year prices.
The chained-dollar method uses the prices of current year and the preceding year.
We show the calculation in fives steps.
We’ve included this material on the chained-dollar method because it is the method actually used today. But it might be too technical for your students. Not much is lost by sticking with the traditional method.

7. 20.3 NOMINAL GDP VERSUS REAL GDP
Step 1:Calculate the value of production in both 2005 and 2006 using the prices of 2005.
In 2005:
Value of apples = 100 apples x $1.50 = $150
Value of oranges = 200 oranges x $0.75 = $150
Nominal GDP in 2005 = $150 + $150 = $300

8. 20.3 NOMINAL GDP VERSUS REAL GDP
Value of apples = 160 apples x $1.50 = $240
Value of oranges = 220 oranges x $0.75 = $165
2006 Quantities at 2005 prices = $240 + $165 = $405

9. 20.3 NOMINAL GDP VERSUS REAL GDP
Using 2005 prices:
Value of production in 2005 is $300.
Value of production in 2006 is $405.
So using 2005 prices, the value of production increased by $105 or 35 percent in 2006.

10. 20.3 NOMINAL GDP VERSUS REAL GDP
Step 2:Calculate the value of production in both 2005 and 2006 using the prices of 2006.
In 2005:
Value of apples = 100 apples x $1.00 = $100
Value of oranges = 200 oranges x $2.00 = $400
2005 Quantities at 2006 Prices = $100 + $400 = $500

11. 20.3 NOMINAL GDP VERSUS REAL GDP
Value of apples = 160 apples x $1.00 = $160
Value of oranges = 220 oranges x $2.00 = $440
Nominal GDP in 2006 = $160 + $440 = $600

12. 20.3 NOMINAL GDP VERSUS REAL GDP
Using 2006 prices:
Value of production in 2005 is $500.
Value of production in 2006 is $600.
So using 2006 prices, the value of production increased by $100 or 20 percent in 2006.

13. 20.3 NOMINAL GDP VERSUS REAL GDP
Step 3: Calculate the average of these increases in production:
35 percent with 2005 prices
20 percent with 2006 prices
The average of 35 percent and 20 percent is 27.5 percent—our estimate of the real GDP growth rate between 2005 and 2006.
Table 20.6(a) summarizes this calculation.

14. 20.3 NOMINAL GDP VERSUS REAL GDP

15. 20.3 NOMINAL GDP VERSUS REAL GDP
Step 4
Repeat the calculations for each year going back to the base year, so we have an estimate of the real GDP growth rate from the base year of 2000.
Step 5
Starting from real GDP (nominal GDP) in the base year use the real GDP growth rates to calculate real GDP each through to 2006.
Table 20.6(b) this calculation.

16. 20.3 NOMINAL GDP VERSUS REAL GDP

17. 20.3 NOMINAL GDP VERSUS REAL GDP
Calculating the GDP Deflator
GDP deflator
An average of current prices expressed as a percentage of base-year prices.
GDP deflator measure the price level.
GDP deflator = (Nominal GDP  Real GDP)  100.

18. 20.3 NOMINAL GDP VERSUS REAL GDP
We calculated the in 2006:
Nominal GDP = $600 and real GDP = $145
GDP deflator = (Nominal GDP ÷ Real GDP) x 100
So in 2006:
GDP deflator = ($600 ÷ $145) x 100 = 414.

19. 20.4 THE USE AND LIMITATIONS OF REAL GDP
We use estimates of real GDP for two main purposes:
To compare the standard of living over time
To compare the standard of living among countries
The Standard of Living Over Time
To compare living standards we calculate real GDP per person—real GDP divided by the population.
Table 20.8 shows two calculations

20. 20.4 THE USE AND LIMITATIONS OF REAL GDP

21. 20.4 THE USE AND LIMITATIONS OF REAL GDP
Long-Term Trend
Figure 20.3 shows the long-term trend in U.S. real GDP per person.
Real GDP per person doubled on the 33 years from 1965 to 1998.

22. 20.4 THE USE AND LIMITATIONS OF REAL GDP
Short-Term Fluctuations
Fluctuations in the pace of expansion of real GDP is called the business cycle.
The business cycle is a periodic irregular up-and down movement of total production and other measure of economic activity.
The four stages of a business cycle are expansion, peak, recession, and trough.

23. 20.4 THE USE AND LIMITATIONS OF REAL GDP
The shaded periods show the recessions– periods of falling production that lasts for at least six months.

25. 20.4 THE USE AND LIMITATIONS OF REAL GDP
Standard of Living Across Countries
To compare living standards across countries, we must convert real GDP into a common currency and common set of prices, called purchasing power parity.
Goods and Services Omitted from GDP
Household production
Underground production
Leisure time
Environment quality
A discussion of omissions from GDP can arouse students’ interest. For example, you might point out that if one of your students mows her/his own lawn, the value of the student’s production doesn’t show up in GDP. But if you hire the student to mow your lawn (and if your student reports the income earned correctly to the IRS), the value of the student’s production does show up in GDP. Why don’t we measure all lawn mowing as part of GDP? Some reasons are cost of collecting data and the degree of intrusiveness we’d be willing to tolerate. But note how little we spend on collecting the GDP data and how relatively inexpensive it would be to add some questions about domestic production to either the Labor Force Survey or the Family Expenditure Survey. You might like to explain how the omission of illegal goods and services also leads to some misleading comparisons. For instance, the day before prohibition ended, the production of illegal beer was not counted as part of GDP. But the day after prohibition ended, the production of now legal beer counted. Ask your students to suggest two good reasons why illegal goods and services are omitted. First, the data are hard but not impossible to obtain. Second, there may be the moral position that illegal activities should not be included in GDP. This latter observation can lead to an interesting discussion. Ask the students if they think that the production of, say, marijuana should be included in GDP. Some, maybe even many, of them will see no problem with this. Then ask about the production of murder-for-hire. The response, we hope, will be significantly different. Does such a good have any value?

26. 20.4 THE USE AND LIMITATIONS OF REAL GDP
Household Production
Real GDP omits household production, it underestimates the value of the production of many people, most of them women.
Underground Production
Hidden from government to avoid taxes and regulations or illegal.
Because underground economic activity is unreported, it is omitted from GDP.

27. 20.4 THE USE AND LIMITATIONS OF REAL GDP
Leisure Time
Our working time is valued as part of GDP, but our leisure time is not.
Environment Quality
Pollution is not subtracted from GDP.
We do not count the deteriorating atmosphere as a negative part of GDP.
If our standard of living is adversely affected by pollution, our GDP measure does not show this fact.

28. 20.4 THE USE AND LIMITATIONS OF REAL GDP
Other Influences on the Standard of Living
Health and Life Expectancy
Good health and a long life do not show up directly in real GDP.
Political Freedom and Social Justice
A country might have a very large real GDP per person but have limited political freedom and social justice.
A lower standard of living than one that had the same amount of real GDP but in which everyone enjoyed political freedom.
You can generate a productive classroom discussion on the topic of this slide.