Real and nominal GDP
How to separate growth in output from rising prices, using real GDP and the GDP deflator, and how good a measure of well-being GDP is.
FinanceEveryday economicsAbout 5 min: 3 reading, 2 practiceUpdated
General education, not financial advice.
- Calculate nominal GDP, real GDP and the GDP deflator
- Work out growth and inflation from them
- Explain what GDP leaves out as a measure of well-being
Builds toward: Run your own money. Budget so there's room to save, spot and clear costly debt, compare savings and loan offers, and see what interest and inflation do to your money.
Everyday economics: news, prices and choices: lesson 9 of 11
- Everyday economics
- Trade-offs and opportunity cost 5 min
- Thinking at the margin and incentives 5 min
- Models and the circular flow 5 min
- Positive and normative statements 6 min
- Demand and what shifts it 5 min
- Supply, equilibrium and shifts 6 min
- What money is 5 min
- What GDP counts 6 min
- Real and nominal GDP 5 min
- Measuring unemployment 5 min
- The costs of inflation 6 min
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Pairs with any introductory economics textbook; for example N. Gregory Mankiw, Principles of Macroeconomics (6th ed.), chapter 10
What it is
Total spending can rise because more is produced or because prices are higher. To separate the two:
- Nominal GDP values output at current prices.
- Real GDP values output at the prices of a fixed base year, so it changes only when quantities change.
- The GDP deflator = nominal GDP ÷ real GDP × 100. It measures the price level relative to the base year, which always has a deflator of 100.
Mankiw's example economy makes only hot dogs and hamburgers (base year 2010):
| Year | Hot dogs | Hamburgers |
|---|---|---|
| 2010 | 100 at 1 | 50 at 2 |
| 2011 | 150 at 2 | 100 at 3 |
| 2012 | 200 at 3 | 150 at 4 |
| Year | Nominal | Real | Deflator |
|---|---|---|---|
| 2010 | 200 | 200 | 100 |
| 2011 | 600 | 350 | 171 |
| 2012 | 1,200 | 500 | 240 |
Real GDP for 2011, for example, values 2011's quantities at 2010's prices: 1 × 150 + 2 × 100 = 350.
Quick check
Tap an answer to check it.
Nominal GDP is 900 and real GDP is 750. What is the GDP deflator?
- That divides real by nominal; divide nominal by real
Show answer
120. 900 ÷ 750 × 100 = 120.
Why it matters
Real GDP measures growth. It tracks how much the economy produces. In the example, real GDP grew from 200 to 350, a rise of 75%, from 2010 to 2011. Real GDP usually rises over time, but falls in recessions. Mankiw notes an old rule of thumb that a recession is two quarters in a row of falling real GDP, though the official US dating committee has no fixed rule.
The deflator measures inflation. Inflation from one year to the next is the percentage change in the deflator: from 171 to 240 is about 40%.
Is GDP a good measure of well-being? GDP per person is a natural measure of the average person's income and spending, but Mankiw lists what it leaves out:
- Leisure: if everyone worked every weekend, GDP would rise, but people might not be better off.
- Home production: cooking, cleaning and childcare done at home are not counted.
- The environment: pollution that harms health is not subtracted.
- Distribution: GDP per person says nothing about how income is shared.
Robert Kennedy, in 1968, criticised such measures, saying they measure everything "except that which makes life worthwhile". Mankiw's answer: GDP doesn't measure those things directly, but a higher GDP helps a country afford good schools and healthcare. Across countries, higher GDP per person goes with longer lives and higher literacy.
Worked example
An economy making apples and books. Base year: year 1.
| Year | Apples | Books |
|---|---|---|
| 1 | 100 at 2 | 20 at 10 |
| 2 | 110 at 3 | 25 at 12 |
- Nominal GDP: year 1 = 2 × 100 + 10 × 20 = 400; year 2 = 3 × 110 + 12 × 25 = 630.
- Real GDP (year-1 prices): year 1 = 400; year 2 = 2 × 110 + 10 × 25 = 470.
- Deflator: year 1 = 100; year 2 = 630 ÷ 470 × 100 ≈ 134.
- Real growth: 470 ÷ 400 − 1 = 17.5%. Inflation (deflator): about 34%.
Nominal GDP rose 57.5%, but less than a third of that rise came from producing more.
Common mistake
Reading a rise in nominal GDP as growth. Nominal GDP can rise purely because prices rose. Only real GDP tells you whether the economy produced more.
Key terms
- nominal GDP
- the production of goods and services valued at current prices
- real GDP
- the production of goods and services valued at constant (base-year) prices
- GDP deflator
- nominal GDP ÷ real GDP × 100: a measure of the price level
- base year
- the year whose prices are used to value output in every year
- recession
- a period of falling real GDP
Practise the key terms
Tap a card to turn it over. 5 cards.
| Front | Back |
|---|---|
| nominal GDP | the production of goods and services valued at current prices |
| real GDP | the production of goods and services valued at constant (base-year) prices |
| GDP deflator | nominal GDP ÷ real GDP × 100: a measure of the price level |
| base year | the year whose prices are used to value output in every year |
| recession | a period of falling real GDP |
Practice
Work it through
Base year 1. Year 1: 50 shirts at 10. Year 2: 60 shirts at 12.
- 60 × 12
- 60 × 10 (base-year price)
- 720 ÷ 600 × 100
- 600 ÷ 500 − 1, × 100
Quick quiz
Tap an answer to check it.
In the base year, how do real and nominal GDP compare?
- Both use the same prices in the base year
Show answer
They are equal, so the deflator is 100. Real GDP uses base-year prices, which in the base year are current prices.
Which of these does GDP leave out, in Mankiw's list?
- Market services are counted
- Counted as investment
Show answer
The value of leisure. More work and less leisure can raise GDP without making people better off.
Nominal GDP rises 8% and the deflator rises 5%. About how much did real GDP grow?
- Real growth is roughly nominal growth minus inflation
- Part of the nominal rise is higher prices
Show answer
About 3%. Real GDP growth ≈ nominal growth − inflation.
In short
- Nominal GDP: current prices. Real GDP: base-year prices. Deflator: nominal ÷ real × 100.
- Real GDP measures growth; the deflator measures inflation.
- GDP leaves out leisure, home production, the environment and distribution.
- Still, higher GDP per person goes with longer, healthier, more literate lives.
Mastery check
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In Mankiw's example, what is the GDP deflator in 2012?
Show answer
240 (1,200 ÷ 500 × 100).
What is an old rule of thumb for a recession?
Show answer
Two quarters in a row of falling real GDP.
Why is real GDP a better measure of output than nominal GDP?
Show answer
It is not affected by changes in prices.
Further reading
- N. Gregory Mankiw, Principles of Macroeconomics, 6th ed. (South-Western Cengage, 2012), chapter 10.
- On this site: What GDP counts and Measuring inflation with a price index.
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