83 Converting Nominal to Real GDP
Learning Objectives
- Calculate real GDP based on nominal GDP values
- Calculate the real growth rate in GDP
Now we’re in a position to answer the question that we posed previously: given nominal GDP for the U.S. economy from 1960-2010, how much did real GDP actually increase?
In order to see how much production has actually increased, we need to extract the effects of higher prices on nominal GDP, so that what we’re left with is real GDP, the increase in the quantity of goods and services produced. This can be easily done using a concept known as the GDP deflator. The GDP deflator is a price index measuring the average price of all goods and services included in the economy. We will explore price indices in detail and how they are computed when we learn more about inflation, but this definition will do for now. The data for the GDP deflator are given in Table 1 and shown graphically in Figure 1.
| Table 1. U.S. GDP Deflator, 1960-2010 | ||
| 1960 | 19.0 | |
| 1965 | 20.3 | |
| 1970 | 24.8 | |
| 1975 | 34.1 | |
| 1980 | 48.3 | |
| 1985 | 62.3 | |
| 1990 | 72.7 | |
| 1995 | 81.7 | |
| 2000 | 89.0 | |
| 2005 | 100.0 | |
| 2010 | 110.0 | |
| Source: www.bea.gov, National Accounts |
Figure 1 shows that the price level, as measured by the GDP deflator, has risen dramatically since 1960. Using the simple growth rate formula that we explained on the last page, we see that the price level in 2010 was almost six times higher than in 1960 (the deflator for 2010 was 110 versus a level of 19 in 1960). Clearly, much of the apparent growth in nominal GDP was due to inflation, not an actual change in the quantity of goods and services produced, in other words, not in real GDP. Recall that nominal GDP can rise for two reasons: an increase in output, and/or an increase in prices. What is needed is to extract the increase in prices from nominal GDP so as to measure only changes in output. After all, the dollars used to measure nominal GDP in 1960 are worth more than the inflated dollars of 1990—and the price index tells exactly how much more. This adjustment is easy to do if you use the Nominal-to-Real formula that we explained previously:
[latex]\text{Nominal Value of Output}=\text{Price}\times\text{Quantity of Output}[/latex]
Taking the GDP form of this equation:
[latex]\text{Nominal GDP}=\text{GDP Deflator}\times\text{Real GDP}[/latex]
Divide both sides by the GDP Deflator:
[latex]\displaystyle\text{Real GDP}=\frac{\text{Nominal GDP}}{\text{GDP Deflator}}[/latex]
For reasons that will be explained in more detail below, mathematically, a price index (like the GDP Deflator) is a two-digit decimal number like 1.00 or 0.85 or 1.25. Because some people have trouble working with decimals, when the price index is published, it has traditionally been multiplied by 100 to get integer numbers like 100, 85, or 125. What this means is that when we “deflate” nominal figures to get real figures (by dividing the nominal by the price index), w