Adjusting Nominal Values to Real Values
Learning Objectives
By the end of this section, you will be able to:
- Contrast nominal GDP and real GDP
- Explain GDP deflator
- Calculate real GDP based on nominal GDP values
When examining economic statistics, there is a crucial distinction worth emphasizing. The distinction is between nominal and real measurements, which refer to whether or not inflation has distorted a given statistic. Looking at economic statistics without considering inflation is like looking through a pair of binoculars and trying to guess how close something is: unless you know how strong the lenses are, you cannot guess the distance very accurately. Similarly, if you do not know the inflation rate, it is difficult to figure out if a rise in GDP is due mainly to a rise in the overall level of prices or to a rise in quantities of goods produced. The nominal value of any economic statistic means that we measure the statistic in terms of actual prices that exist at the time. The real value refers to the same statistic after it has been adjusted for inflation. Generally, it is the real value that is more important.
Converting Nominal to Real GDP
Table 1 shows U.S. GDP at five-year intervals since 1960 in nominal dollars; that is, GDP measured using the actual market prices prevailing in each stated year. Figure 1 also reflects this data in a graph.
| Year | Nominal GDP (billions of dollars) | GDP Deflator (2005 = 100) |
|---|---|---|
| 1960 | 543.3 | 19.0 |
| 1965 | 743.7 | 20.3 |
| 1970 | 1,075.9 | 24.8 |
| 1975 | 1,688.9 | 34.1 |
| 1980 | 2,862.5 | 48.3 |
| 1985 | 4,346.7 | 62.3 |
| 1990 | 5,979.6 | 72.7 |
| 1995 | 7,664.0 | 81.7 |
| 2000 | 10,289.7 | 89.0 |
| 2005 | 13,095.4 | 100.0 |
| 2010 | 14,958.3 | 110.0 |
If an unwary analyst compared nominal GDP in 1960 to nominal GDP in 2010, it might appear that national output had risen by a factor of more than twenty-seven over this time (that is, GDP of $14,958 billion in 2010 divided by GDP of $543 billion in 1960 = 27.5). This conclusion would be highly misleading. Recall that we define nominal GDP as the quantity of every good or service produced multiplied by the price at which it was sold, summed up for all goods and services. In order to see how much production has actually increased, we need to extract the effects of higher prices on nominal GDP. We can easily accomplish this using the GDP deflator.
The GDP deflator is a price index measuring the average prices of all goods and services included in the economy. We explore price indices in detail and how we compute them in Inflation, but this definition will do in the context of this chapter. Table 1 provides the GDP deflator data and Figure 2 shows it graphically.
Figure 2 shows that the price level has risen dramatically since 1960. 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 growth in nominal GDP was due to inflation, not an