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Learn how to adjust economic output for inflation using real GDP. This calculation enables economists to remove the effect of rising prices and more accurately compare economic output from multiple years.
I want you to go with me to Econoworld, where at this very moment, President Arnold is sitting in his Oval Office while he's taking a break. He asked his assistant for two things to be brought up, and now he's enjoying them both: high-quality headphones that he can use to listen to the brand-new music download that he's purchased online and some cheesecake to go with it. The nation of Macro produces only two goods - music downloads and cheesecake. That's it. That's all they eat and all they do, all day.
Just before the president finishes his cheesecake, he is interrupted by his chief economist, who brings in the newly-completed Economic Report of the President. This is good stuff; a very good read. As a matter of fact, it's filled with economic statistics and a proposed budget for the entire economy. Also contained within the report is information on the economic output of the nation for the years 2011 and 2012. With the help of the Council of Economic Advisors, every president publishes this report annually, which contains an overview of the nation's economic progress.
Let's open up the book and take a closer look at economic output in the nation of Macro.
Nominal gross domestic product is the total market value of goods and services produced, measured in current dollars. It represents current quantities at current prices. On the other hand, real gross domestic product is the total market value of goods and services produced, measured in constant dollars. It represents current quantities at past prices.
As you can see, the price of music downloads increased from $1 to $2, while the price of cheesecake, if you notice, went up by 20%.
At these prices, the nation produced 100 downloads the first year and 150 the second year. Cheesecake was another story. I'm told that the majority of the 20 cheesecakes produced in 2011 were made for President Arnold. Notice that in 2012, the quantity of cheesecakes produced dropped to 15. That's because the prez had a cholesterol scare and had to cut back on the cake. Whenever he wanted that piece of cheesecake, he valiantly resisted and instead listened to a download of his favorite classic song, 'Cut the Cake,' by Average White Band.
What we want to know is how much did the nation really grow between these two years?
First, I'll show you how to calculate nominal GDP. Then, we'll adjust it for inflation to get real GDP, which removes the effect of rising prices and enables us to make an apples-to-apples comparison. The prices and quantities of these two goods are listed below for the years 2011 and 2012.
By definition, GDP is the total market value of goods and services produced. Since market value = price * quantity, it means we multiply the price times the quantity for all goods in the economy and add them up for every year we're looking at. Nominal GDP represents current quantities at current prices, so we use the 2011 prices for the 2011 nominal GDP, and we use the 2012 prices for the 2012 nominal GDP.
We're going to make 2011 what economists call 'the base year,' which means that it's the year we will compare 2012 to. In the base year, nominal GDP and real GDP are always going to be the same.
To get the nominal GDP in the first year, we use the prices for that year, as follows:
Nominal GDP in 2011 = (Price of downloads in 2011 * Quantity of downloads in 2011) + (Price of cheesecake in 2011 * Quantity of cheesecake in 2011)
So plugging in the numbers here, we have ($1.00 * 100) for the downloads, and then we have ($10.00 * 20) for the cheesecake, which equals $100 + $200, for a total of $300. So that was the nominal GDP in 2011.
Next, we calculate the nominal GDP in 2012, as follows. We have the same formula, but we're using different information this time for 2012.
($2.00 * 150 downloads) + ($12.00 * 15 cheesecakes), which equals $300 + $180, for a total of $480. So that's our nominal GDP in 2012. So we have $300 nominal GDP in 2011 and $480 in nominal GDP in 2012.
As we quickly compare the nominal GDPs from these years, it appears that economic output went up substantially, from $300 to $480, right?
Now, let's calculate real GDP in both years, which will enable us to adjust for inflation and compare apples to apples. Remember that real GDP represents current quantities at past prices. However, real GDP in the base year is always the same as the nominal GDP in the base year because that's the year that the other year is being compared to. So here's the formula for real GDP in 2011:
Real GDP in 2011 = (Price of downloads in 2011 * Quantity of downloads in 2011) + (Price of cheesecake in 2011 * Quantity of cheesecake in 2011)
Plugging in the numbers, we have ($1.00 * 100) + ($10.00 * 20), which equals $100 + $200, for a total of $300. Remember, I said that the nominal GDP and the real GDP are going to be the same in the base year, so this is what we found.
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To calculate real GDP in 2012, we're going to use the quantities produced in 2012 but the prices in 2011. Why? It's the current quantities at past prices (that's what real GDP means) and the base year is 2011. If the base year was another year before that, then we'd use that year instead. We always replace the current year prices with the base year prices because prices have changed, and we're trying to remove the effect of this change in prices. In essence, what we're saying is, 'How much output would we have ended the year with if the nation produced the amount of stuff it produced in 2012 but sold it at 2011 prices?' Here's what the calculations for 2012 real GDP look like:
Real GDP in 2012 = (Price of downloads in 2011 * Quantity of downloads in 2012) + (Price of cheesecake in 2011 * Quantity of cheesecake in 2012)
This equals ($1.00 * 150) + ($10.00 * 15), and that is $150 + $150, for a total of $300.
Now we have all the information we need to make an informed judgment about how much the economy really grew.
Although nominal GDP says that Macro's economic output was $480 during 2012, after adjusting for inflation, economic output was only $300, which is exactly the same output as the year before. Economists would say it this way: 'There was no real growth in the nation of Macro between 2011 and 2012.'
So, what did we learn?
Gross domestic product can increase for two reasons - because quantity increased or because prices increased. What we want to know is how much more did we really produce, and real GDP tells us what we want to know by removing the effect of rising prices.
Let's summarize the key points from this lesson. Gross domestic product is the total market value of goods and services produced within the domestic borders of a nation during the year.
Nominal gross domestic product is the total market value of goods and services produced, measured in current dollars. It represents current quantities at current prices.
By definition, GDP is the total market value of goods and services produced. Since market value = price * quantity, it means that we multiply the price times the quantity for all goods in the economy and add them up for every year that we're looking at.
The major drawback of using nominal GDP is that it creates a false impression of the amount of output taking place in a nation from one year to the next due to the change in prices.
On the other hand, real gross domestic product is the total market value of goods and services produced, measured in constant dollars. It represents current quantities at past prices.
How do we account for this? We adjust a nation's nominal GDP by any increase in the price level that took place. In other words, we adjust GDP for inflation. Economists call the new adjusted number 'real GDP' because it tells us how much production really increased from one year to the next.
To calculate real GDP in a certain year, multiply the quantities of goods produced in that year by the prices for those goods in the base year.
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