Compare Nominal and Real GDP and Calculate and Interpret the GDP Deflator

It is economically healthy to exclude the effect of general price changes when calculating the GDP. This is because higher (lower) income caused by inflation does not indicate a higher (lower) level of economic activity.

Real GDP

Economists describe real GDP as what would have been the total expenditure on the output of goods and services if prices of the same were not altered. It represents the market value of goods and services if prices don’t change over time, i.e., it holds prices constant to separate actual growth from inflation.

Per capita real GDP, which is the real GDP divided by the population size, regularly measures the living standards of the citizens of a given country.

Nominal GDP

On the other hand, nominal GDP refers to the value of goods and services measured at the current market prices, i.e., it uses the actual prices paid at any point in time.

Example of Real and Nominal GDP

Take an economy with a single fruit farm that produced 100,000 oranges with an average market price of $0.10 in 2018. The Gross Domestic Product in 2018 (nominal GDP) would be 0.10×100,000=$10,000.

Suppose 100,000 oranges are produced in the year 2019 but at an increased market price of 10% per orange, which will give an average market price of $0.11 per orange. The nominal GDP in 2019 would be 0.11×100,000=$11,000$=$11,000 while the real GDP for 2019 will remain at $10,000 because we assumed the base year (2018) price in our calculation of real GDP. The GDP in the year 2019 would be $11,000.

It might look like the economy grew between 2018 and 2019, even when constant production of oranges was witnessed. Actually, the economy did not grow at all because the same number of oranges was produced. This is what economists refer to as inflation.

GDP Deflator

GDP deflator is also called implicit price deflator for GDP. It is simply the ratio of Nominal GDP to Real GDP and is expressed as:

$$\text{GDP}_{deflator} = \frac{\text{Nominal}_{GDP}}{\text{Real}_{GDP}} × 100$$

Where:

\(\text{Nominal GDP}\) = value of current year output at current prices

\(\text{Real GDP}\) = value of current output at base year prices

Using the example above, the GDP deflator for the year 2019 is:

$$\frac{11,000}{10,000} × 100 = 110$$

The GDP deflator measures the aggregate changes in prices in the overall economy of a country. Therefore, changes in the deflator are used to calculate the level of inflation within the economy.

Example of GDP Deflator

Last year, automakers sold 1,000 cars at $20,745 each on average. This year, automakers sold 1,000 cars at $21,175 each on average. Calculate the GDP deflator.

Solution

Nominal GDP (last year) \(= 1,000 \times 20,745=$20,745,000\)

Nominal GDP (this year) \(=1,000\times 21,175=$21,175,000\)

Real GDP (last year) \(= 1,000\times 20,745=$20,745,000\)

Real GDP (this year) \(= 1,000\times 20,745=$20,745,000\)

Now, capturing the impact of inflation using the GDP deflator, we have:

$$\text{GDP Deflator} = \frac{\text{Nominal}_{GDP}}{\text{Real}_{GDP}} × 100=\frac{21,175,000}{20,745,00} \times 100 =102.07$$

From the values above:

In nominal terms, we see 2.07% GDP growth. That is, nominal GDP increase from $20,745,000 to $21,175,000.

In real terms, there was 0% GDP growth since it is still 1,000 cars sold.

Therefore, 2.07% is the inflation rate in the economy.

Question

Which among the following is the most accurate statement about the GDP deflator?

A. It is used to calculate the value of goods and services at current year prices.

B. It is used to calculate the value of goods and services at base-year prices.

C. It is used to calculate the aggregate changes in prices in the overall economy.

Solution

The correct answer is C.

The GDP deflator uses the value of goods and services at current year prices and the value at base-year prices. A ratio of the two gives the GDP deflator.