Nominal and Real GDP

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Nominal and Real GDP
PRINCIPLES OF MACROECONOMICS

• Dr. Fidel Gonzalez
• Department of Economics and Intl. Business
• Sam Houston State University

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The GDP is market value of all final goods and
services for a given year within a region. If P
is the price level of an economy and Q is the
production, then GDP P x Q
Imagine now how it will be for several years (say
for 2000 to 2005)
Table 1. Nominal GDP
Most of the time we want to know what happened to
Q. That is, we want to know if production went up
or down and by how much. Why? Because as I
pointed out before production is equal to income.
Income is very important because it is a proxy
for happiness.
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However, the table in the previous slide does not
help us much. It only tell us what happened to
the multiplication of P and Q but not what
happened only to Q. For instance from 2003 to
2004 GDP increase by 28. However, it could have
been because production when up and prices went
down, or prices went up and production down, or
all both went up. In other words, I cannot
distinguish between changes in P and changes in
Q. In order to solve this problem we are going to
calculate GDP using the same price. That is, we
are going to use a constant price. This is
called Real GDP. Real GDP is the market value of
all goods and services for a given year and
region using constant prices. Nominal GDP is the
market value of all goods and services for a
given year and region using current prices.
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In order to get constant prices we need to pick
one year and that will be the price level that we
will use. We can really choose any year we want,
so I am going to use the year 2004. The real GDP
will then be
Table 2. Real GDP
I multiply each quantity by the same price so the
difference of GDPs between two years is due only
to change in Q (it is the only thing changing).
Note that I have omitted the value of the real
GDP because we will do that later.
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Now, lets see the following numerical example
(this has different numbers than the example in
class). Imagine the following economy with two
sectors food and cars. We obtain data for three
years 1980, 1981, 1982.
Table 3. Production and Prices
Question What is the Nominal GDP for 1980, 1981
and 1982? Answer GDP1980 (30x23) (2x120)
690 240 930 GDP1981 (36 X 27) (5 x 125)
972 625 1,597 GDP1982 (40 x 39) (8 X
130) 1,560 1,040 2,600
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However, we also want to know what is the Real
GDP for these three years. Question What is the
Real GDP for 1980, 1981 and 1982? Answer First
we need to choose as base year. Lets choose 1981
as the base year. Second, calculate the GDP using
the base year prices for each good cars and
food multiply the quantities of each year for
every good times the respective price in the base
year.
Real GDP1980 (30x27) (2x125) 810 250
1,210 Real GDP1981 (36 X 27) (5 x 125) 972
625 1,597 Real GDP1982 (40 x27) (8 X
125) 1,080 1,000 2,080
Note that the difference between 1980 and 1982 is
not as big as before because we took care of the
fact that prices increase between those years.
Hence, the increase in Real GDP is due to the
fact that production for cars and food increase
between 1980 and 1982. The production of cars was
30 in 1980 and 40 in 1982. The production on food
was 2 in 1980 and 8 in 1982.
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You can see now that Real GDP is very useful when
we compare between years. Also, note that the
Real GDP Nominal GDP for the base year
Important Features of Real and Nominal GDP 1)
Nominal GDP over Real GDP is equal to the price
ratio of the current year and the base year.
The nominal GDP divided by the real GDP is equal
to the price ratio between the current year (1982
in the example above) and the base year (1981 in
the example above). Question What is the
percentage change in the price between 1982 and
the base year (1981).
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Remember that to calculate the percentage change
this is the formula
The percentage change in the price between 1981
and 1982 was 25 or in other words the inflation
rate was 25. We have gone from nominal and real
GDP to price ratios (changes).
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2) GDP Deflator is equal to Nominal GDP over Real
GDP. Before we finish with real and nominal GDP
we need to have one last definition. The price
ratio at the end of Equation (1) in the previous
slide is called the GDP deflator.
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Question What is the GDP deflator for
1981? Since the real and nominal GDP are the same
for the base year (1981 in this case), the GDP
deflator will be 1 (or 100). Question What is
the GDP deflator for 1980?
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It is a common mistake in students to think that
the GDP deflator is the price ratio between the
current and the previous year, but as you can see
that is not true. For instance, imagine that
you look at the government statistics and they
tell you that the GDP deflator for 1983 was 1.5
(or 150). Questions What does this tell you
about the change in prices? Answer This tell you
that prices increase 50 between 1981 and 1983.
That is, in two years prices increase by 50.
(it does NOT tell you that prices increase 50
in 1983, be careful) Finally, note that the
relationship between percentage price change and
GDP deflator is very close (GDP deflator 1
)x100 Percentage Change in price Inflation
rate
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GDP Deflator
The GDP deflator is a very important concept. It
is useful because it helps us to obtain Real GDP
and we can also use it to get the inflation rate.
In the rest of these slides we will cover how to
compute the GDP deflator.
Therefore, in order to compute the GDP deflator I
need to obtain the price level of each year.
Once, I know the price level of each year then I
can divide the current year (P1982) by the base
year price level (P1981) to get the GDP
deflator. Thus, our next task is to figure out
how to compute the Ps. The question is then how
do we calculate the GDP deflator or the prices.
It is not as easy as you might think because the
economy has millions of different prices price
of gasoline, price of chewing gum, price of beer,
etc. We are going to consider two approaches to
compute the Ps.
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A) The simplest approach. One possibility you
might think is to add up all the prices in the
economy for a particular year and that is the
price level. Then, divide prices by one year and
I will obtain the GDP, if I subtract one to that
number I will get the percentage price
change. Hence adding up the prices in Table 3, I
obtain the following P1980 143 P1981
152 P1982 169
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Next, I obtain the GDP deflator for each year
This information tells me that the overall price
level in the economy increased by 44 between
1981 and 1982.
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However, there is a big problem with this
approach it assumes that all good have the same
importance in the economy. That is, a one dollar
increase in the price of food is the same as one
dollar increase in the price of cars. This is
unrealistic, why should cars and food have the
same importance if the total value of the
production of cars and food are different ? For
instance, imagine that the price of chewing gum
goes up by one dollar and the price of gasoline
goes up by one dollar. I am sure that for
most people the increase in the price of gasoline
is more important than the increase in the price
of chewing gum. This is a result of the fact that
people spend a bigger proportion of their income
in gasoline than in chewing gum. Hence, the
simplest approach is not good!!!!!!
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B) Weighted approach. We are going to solve this
problem calculating the GDP deflator by weighting
the price of each good according to their
contribution to the GDP. The first thing I am
going to do is obtain the weight of each good in
the economy for the base year. Remember that I
can pick any year as the base year. To be
consistent I will choose my base year to be 1981
again.
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Step 1. Obtain the weights for all the goods
As you can see that sum of all the weight is
equal to 1 Step 2. Obtain the price increases
for each good with respect to the base year.
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Step 3. Multiply the price increase by the weight
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As you can see the difference is big between the
first approach and the second approach. In the
first one, we obtained that the price increase
between 1981 and 1982 was 11 in the second the
price change was 28.2. Remember, that the second
approach is the correct one. The second
approach to obtain the GDP deflator is called a
price index using the Laspeyres approach. What
makes this price index a Laspeyres index is that
the weights are set using the base year and never
change. Laspeyres indexes are widely used in
economics.