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Nominal GDP versus Real GDP

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Hi, welcome to Macroeconomics. This is Kate. This tutorial is on nominal versus real GDP. As always, my key terms are in red, and my examples are in green.

In this tutorial, we'll be looking at the difference between nominal and real GDP. I'll talk about why when we're comparing two different years it's really important to use real GDP. And I'll end by looking at how we need to also understand the difference between nominal and real interest rates when we're talking about borrowing and lending money.

Let's start out with a reminder as to what GDP is. GDP stands for Gross Domestic Product, and it's when we add up all the final goods and services that are produced or sold within a country's borders. It's how we measure economic activity. So when we compare GDP from one year to the next, what we're trying to see is, are we more productive from one year to the next. Is there more or less economic activity going on, within a country's borders.

The example that I wanted to use was this question here. How much has the economy grown since I was born in 1980? Are we more productive today? I would imagine that we are. But how much more productive?

So I looked it up. And I found that GDP, back in 1980, was about $2.8 trillion, or $2,800 billion. Very often, economists like to take this down to per person in the country, and we call that per capita GDP. And per capita, back then, that equated to about $12,500 per person, in terms of productivity.

So GDP in 2012 was over $16 trillion dollars or $16,000 billion. Per capita, that was about $50,000 per person, per year. So I'm looking at that, and I'm asking the question to myself, has the economy really grown six times its size since I was born? Because that's about what the difference between the GDP is.

Or we can also say, do people really have four times the amount of stuff today? That's how it would be in the per capita. Is that really how much more productive or more stuff we have, than back in 1980?

So again, remember the point of measuring GDP is to see how productive the economy is from quarter to quarter or year to year. Does our economy actually produce almost six times the amount of goods and services as we did in 1980? Or has our GDP increased so much due to something else? And that's what the topic of this tutorial is all about.

In 1980 our GDP, like I said, was $2,800 billion and or $2.8 trillion, and in 2012 it was $16 trillion. What's really important to understand-- and this is kind of the key idea of this tutorial-- is that those figures there are expressed in those years prices. And that's what we call nominal GDP.

So nominal is a value of an economic variable, like GDP or inflation or prices in the current period. And it doesn't reflect changes in purchasing power or the price level over time. So nominal GDP then is the value of GDP, which includes the impact of inflation.

So when we're looking at those figures, what we need to understand is that certainly I think we are more productive-- we'll see in a minute here. But prices have risen significantly since 1980. So those figures are taking into account the fact that prices have gone up so much. And that's why they're so inflated.

If we look at this-- I just came up with one example. The price of a McDonald's hamburger back in 1980 was about $0.40. The price of a McDonald's hamburger today is somewhere around $1. I'm really estimating here, just to prove the point easily. So in this example alone, though, prices have risen by at least 2.5 times.

Here's a definition of price for you. It's the cost of a good or service. And remember, we're talking about nominal prices right now. Nominal prices reflect the current or prevailing price for an item, whereas real prices, which is where I'm going to go with this, adjust for that inflation.

So what we can do is we can say, let's assume that almost everything-- this is a big assumption-- but if we assume that almost everything has risen by at least 2.5 times in price level since 1980, then what we can look at is today's $50,000 per capita GDP. If we divide that by 2.5, that tells us that the average person today makes the equivalent of $20,000 back in 1980 prices.

Or we could look at it a different way. We could say that 1980's $12,500 per capita GDP is about the equivalent of $31,250 in today's prices. So you can see, certainly we are more productive. We are people that $12,500 per capita GDP is not as much as our $50,000 per capita GDP. But it's not by the amount that initially it looked like, if we were only looking at nominal GDP.

So when we're comparing these, we want to see what is the impact of inflation versus what is the impact of actually producing more goods and services. So that's where this real value takes us. Real is the value of an economic variable, like GDP inflation or prices in the current period, but once we adjust it for the change in the price level over time.

So then real GDP adjusts for inflation by restating nominal GDP, in reference to a base year dollar value. So this is the only way we can compare apples to apples, to really know if an economy has been a more productive from one year to the next. Because it's taking prices out of the equation.

So what we do is we always use a certain year's prices as the base year. So if we're comparing 1980 with 2012, then we need to use one year as the base for both. We would use the prices in 1984 for both years or the prices in 2012 for both years.

So if we do it the way that I've been talking about it, where these were the nominal figures, if we adjusted for inflation and used 1980 prices as the base year, then you would still have your nominal and real GDP in 1980. Using 1980 prices as the base year would still give $2.8 trillion or $2,800 billion for 1980 GDP. But the real GDP in 2012 in 1980 prices would then become $6.4 trillion.

So again, you can see that certainly we are more productive, because $6.4 trillion is greater than $2.8 trillion. But it's not by the amount that is initially looked like, because of the impact of inflation.

We also have to consider the impact on interest rates. So remember, interest rates are what we pay to borrow money. And if I, as a lender, lend someone money and charge them 5%, that's what we would consider the nominal interest rate. But if they pay me back over time, and there's 10% inflation over the years that they're paying me back, they're paying me back in money that's worth less.

So do I really make any money? And the answer is no. Like I said, because they're paying me back in this money worth less and less and less over time, we need to look at what the real interest rate would be. So the real interest rate is where we would take the difference between the nominal interest rate and the rate of inflation. So in this example it would be a negative 5%.

How we would find the rate of inflation from one year to the next is we take the price level in one year, and we divide it by the price level in the last year. So how we measure this is we take a bundle of goods-- and that would be the subject of another tutorial-- but in a very basic example here, if a bundle of goods that cost $100 last year now cost maybe $103 this year, we would then find that the rate of inflation from last year to this year is 3%. Because you would just divide them and that 1.03, that bolded part there, tells us that the rate of inflation is 3%.

So if the rate of inflation was 3%, and the interest rate was 5%, then the real interest rate that banks and other lenders are earning is only 2%, because it's the difference between the nominal interest rate and the rate of inflation. So it's very, very important that we focus on these real figures. Because it tells us how much our purchasing power will actually increase over time, instead of just looking at how much cash we have. Because our cash-- that's great if we have more money, but if it can't purchase more for us, then it doesn't do any good.

Here's a reminder as to what the interest rate effect was, and how interest rates impact spending levels in the economy. You can take a look at that.

So in this tutorial we talked about the difference between nominal and real GDP. We looked at how it's very important to use real GDP when we're comparing two different years. It's the only way that we'll be able to compare quote unquote "apples to apples." And we also have to understand the difference between nominal and real when we're looking at borrowing and lending money in the interest rates market.

Thanks so much for listening, have a great day.