Nominal and real values: correcting for price changes

Overview

Nominal GDP and real GDP and GDP deflator.

What you need to know

Answer each one before you reveal it.

Questions from this subtopic

Each one with the model answer underneath.

1. 1

   Distinguish between nominal GDP and real GDP.

   Model answer

   Nominal GDP values output at the prices ruling in the year it was produced, so it changes when either the quantity of output or the price level changes. Real GDP values output at the prices of a chosen base year, so it changes only when the quantity of output changes. Real GDP is therefore the measure to use when the question is whether the economy has genuinely produced more.

2. 2

   What is the GDP deflator, and what does it measure?

   Model answer

   The GDP deflator is a price index covering all the goods and services included in GDP, set equal to 100 in a base year. It measures the average change in the prices of domestically produced output. Dividing nominal GDP by the deflator and multiplying by 100 converts a money figure into a volume figure at base-year prices.

3. 3

   Nominal GDP is 2,370 billion pounds and the GDP deflator is 118.5 with the base year set at 100. Calculate real GDP at base-year prices.

   Model answer

   Real GDP = nominal GDP × 100 / deflator = 2,370 × 100 / 118.5. Since 118.5 × 20 = 2,370, the calculation gives 2,000. Real GDP is therefore 2,000 billion pounds measured at base-year prices, so prices have risen 18.5 per cent since the base year.

4. 4

   Nominal GDP rises from 2,370 billion pounds to 2,500 billion pounds while the GDP deflator rises from 118.5 to 122.0. Calculate the rate of nominal growth and the rate of real growth.

   Model answer

   Nominal growth = (2,500 - 2,370) / 2,370 = 130 / 2,370 = 0.0549, or 5.49 per cent. Real GDP in year one = 2,370 × 100 / 118.5 = 2,000 billion pounds; real GDP in year two = 2,500 × 100 / 122.0 = 2,049.18 billion pounds. Real growth = (2,049.18 - 2,000) / 2,000 = 0.0246, or 2.46 per cent. Roughly half of the money increase was simply higher prices.

5. 5

   The GDP deflator rises from 118.5 to 122.0 in a year in which nominal GDP grows by 5.49 per cent and real GDP by 2.46 per cent. Calculate the rate of inflation implied by the deflator and comment on the shortcut of subtracting inflation from nominal growth.

   Model answer

   Inflation = (122.0 - 118.5) / 118.5 = 3.5 / 118.5 = 0.0295, or 2.95 per cent. Subtracting this from nominal growth of 5.49 per cent gives 2.54 per cent, against the exact answer of 2.46 per cent. The shortcut is a good approximation at low rates of inflation but drifts away from the true figure as rates rise, because the exact calculation divides rather than subtracts.

6. 6

   Why can nominal GDP rise in a year in which the economy has actually produced less?

   Model answer

   Nominal GDP is quantity multiplied by price, so it rises whenever prices rise fast enough to outweigh a fall in quantity. If output falls by 1 per cent while prices rise by 4 per cent, the money value of output still rises by roughly 3 per cent. Only the real series, which holds prices constant, reveals that production has contracted.

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