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How can you tell how much the economy is really growing from year to year? In this lesson, you'll discover the formulas economists use to calculate real GDP growth rates and draw conclusions about real economic growth.
Let's talk about real GDP growth rates and then look at two examples.
GDP growth rates are kind of like the speedometer on a sports car. Just imagine that Bob, from the town of Ceelo, has done quite well in his lawn business. He just left the mall, where he bought some new designer jeans, and he's driving a new sports car, let's say. The speedometer on Bob's car is going to show how fast he's going at any given time. Now, let's say that Bob is on the city street, where he's traveling at 40 miles an hour. Well, then he enters the expressway, where his speed increases to 60 miles per hour.
When Bob went from the city street to the expressway, he accelerated from 40 mph to 60 mph, which is a 50% increase. Economists basically talk about the same thing when they calculate nominal GDP growth rates to determine how fast the economy accelerated or slowed. Nominal GDP growth measures the actual growth rate from one year to the next. The only major difference is that instead of the 50% rates you can get by using a car as an example, you tend to get much smaller growth rates for major economies, like 2% or 6%.
In order to calculate the growth rate of nominal GDP, we need two nominal numbers in two different years, year 1 and year 2. Here's the formula for calculating GDP growth rates:
(GDP in year 2 / GDP in year 1) - 1
For example, let's suppose that in year 1, which is our base year, the total production in the economy was $16,000. That's our nominal GDP, and it represents current production at current prices. In year 2, the total production (or nominal GDP) was $16,820. So we see that production went up. By how much? Well, let's calculate the growth rate of nominal GDP. When you do the numbers, it works out like this:
($16,820 / $16,000) - 1, which equals 5.1%. That means from year 1 to year 2, nominal GDP in this economy of two goods has increased by 5.1%.
Now imagine that Bob is on the expressway, but it's totally covered with ice. Have you ever driven a car on ice during the wintertime in a cold place? I know I have! Bob's speedometer says he's going 60 miles per hour, but a police radar gun (like the ones they use during the baseball games) says that he's only going 40 miles per hour. When you're trying to go fast on the ice, your tires are doing some spinning underneath you as you drive. The ice is very slippery, and the car tires don't have the same amount of traction on the ice as they do on the regular pavement during summertime, let's say.
Economists recognize that some of the increase in nominal GDP may have been due to a sustained increased in prices, which we call inflation. Inflation is a lot like driving on ice. It makes you feel like you're just spinning your wheels - and hey, let's hope you're not on thin ice! When you think the economy is growing by 6%, it may really be only growing by 3% after inflation.
Inflation subtracts from nominal GDP growth. For this reason, we use real GDP growth rates to remove the effects of rising prices. This process will allow us to draw some conclusions afterwards, and it's what helps fiscal policy leaders and monetary policy leaders interpret the trends in the economy so they can create policies that will promote economic growth.
Nominal GDP growth is like the speedometer in the car when you're driving on ice. It says that you're going faster than you really are. On the other hand, real GDP growth is like the radar gun held by the police, and it measures how fast you're really going. I mean, come on, let's be real. Keepin' it real in Ceelo! Hey, that was a Top 20 radio hit last year, I think.
Good news! We can use the same formula to calculate both nominal and real GDP growth rates. The formula is:
(GDP in year 2 / GDP in year 1) - 1
Let's say that in year 1, which is the base year, real GDP was $16,000. In year 2, real GDP was $16,400. Now we can calculate the growth rate in real GDP because we have two years of data. The growth rate is simply ($16,400 / $16,000) - 1 = 2.5%.
Okay, it's time to draw some important conclusions about the economy. Using the examples that we used here, nominal GDP increased. By how much? 5.1%. Real GDP increased as well. How much did it increase? By 2.5%.
So what initially looks like a 5.1% growth in the economy really turns out to be only 2.5% growth after you factor in the effect of inflation (or the increase in prices between these two years). Hey, if you're driving on ice, you can't always trust the speedometer. See what the radar gun says. That's what real GDP is all about. Did the economy really grow?
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It's time for one more example and another table of economic data. First, let's look at nominal GDP. Nominal GDP in year 1 was $16,000. Nominal GDP in year 2 was $19,320. The growth rate in nominal GDP was ($19,320 / $16,000) - 1, which equals 20.8%. So we see that in nominal terms, the economy grew quite a bit. But some of that growth could have been the result of rising prices, so we want to remove the effects of inflation by using real GDP.
The real GDP in year 1 was the same as the nominal GDP because year 1 is the base year. So this is $16,000. The real GDP in year 2 was $15,500. Therefore, the growth rate in real GDP is ($15,500 / $16,000) - 1, which is equal to -3.1%. What conclusions can we draw about the economy between years 1 and 2? Nominal GDP increased, while real GDP decreased. The economy was in recession.
These are some of the most common observations that economists make, and now you're familiar with real GDP growth rates.
To summarize what we've learned in this lesson, economists use two terms to describe GDP growth rates before and after inflation. One is nominal GDP growth and the other is real GDP growth. Nominal GDP growth is just the actual rate of growth from one year to the next.
If you have actual numbers for nominal GDP, it is very useful to look at how much they've changed from one year to another. This is how you determine whether the economy is accelerating or slowing down. Real GDP growth removes the effects of inflation so you can find out if the economy really grew or not.
This allows economists to draw some important conclusions about how much the economy grew. It's what helps fiscal policy leaders and monetary policy leaders interpret the trends in the economy so they can create policies that will promote growth.
In order to calculate growth rates, we need two numbers in two different years. The general formula for calculating GDP growth rates is as follows:
(GDP in year 2 / GDP in year 1) - 1
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