Nominal vs. Real GDP & the GDP Deflator

1. Nominal GDP vs. Real GDP

The core difference between nominal and real GDP lies in which prices are used for the valuation of output.

• Nominal GDP values the goods and services produced in a given year using that year's current prices. It's calculated as:
  ${\text{Nominal GDP}}_{\text{Year T}}={\text{Price}}_{\text{Year T}}\times {\text{Quantity}}_{\text{Year T}}$
• Real GDP values the goods and services produced in a given year using the prices from a pre-determined base year. This approach holds prices constant, ensuring that any change in Real GDP reflects only a change in the quantity of output. It's calculated as:
  ${\text{Real GDP}}_{\text{Year T}}={\text{Price}}_{\text{Base Year}}\times {\text{Quantity}}_{\text{Year T}}$

Because Real GDP is adjusted for inflation, it is the primary metric economists use to assess the actual growth of an economy's production.

To see this distinction in action, let's watch a video that walks through a clear example.

As the video showed, the nominal GDP growth was a dramatic 26%, but this figure was inflated by rising prices. The real GDP growth, which only reflects the increase in the quantity of apples and oranges produced, was a much more modest 8.6%. This is why, when you hear news reports about economic growth, they are almost always referring to the growth in real GDP.

2. The GDP Deflator: A Measure of the Price Level

We've seen that the difference between nominal and real GDP for a given year comes entirely from changes in prices relative to the base year. We can use this relationship to create a price index that measures the overall level of prices in the economy. This index is known as the GDP Deflator.

The GDP deflator is calculated as the ratio of nominal GDP to real GDP, multiplied by 100.

$\text{GDP Deflator}=\frac{\text{Nominal GDP}}{\text{Real GDP}}\times 100$

Let's break down its interpretation:

• In the base year, Nominal GDP equals Real GDP by definition, so the GDP Deflator will always be 100.
• If in a later year the GDP Deflator is, for example, 110, it means the overall price level has increased by 10% since the base year.
• If the GDP Deflator is 95, it means the overall price level has decreased by 5% since the base year (deflation).

The following short reading and video clip will solidify your understanding of this formula and its application.

Now, let's return to the PrepNuggets video to see the GDP deflator calculated for the 'Tiny Land' example.

An important application of the GDP deflator is to calculate the economy's inflation rate. The inflation rate is simply the percentage change in the GDP deflator from one period to the next.

${\text{Inflation Rate}}_{\text{Year T}}=\left(\frac{{\text{GDP Deflator}}_{\text{Year T}}}{{\text{GDP Deflator}}_{\text{Year T-1}}}-1\right)\times 100\%$

3. Practice and Application

You now have all the tools needed to distinguish between nominal and real GDP and to use the GDP deflator. Let's apply these concepts to some problems, which is the best way to ensure you're ready for the CFA exam.

Exercise 1: CFA-Style Problem

The following exercise from the PrepNuggets video is a typical CFA-style question that requires you to work with growth rates and the GDP deflator.

Exercise 2: Conceptual Check

Consider the following scenario. Think carefully about the relationship between the three variables we've discussed.

Question: If the price level increased and nominal GDP decreased, what must be true about real GDP?
Answer: Real GDP must have decreased.

Reasoning:
The GDP deflator formula can be rearranged to Real GDP = (Nominal GDP / GDP Deflator) * 100. If the price level increases, the GDP deflator increases. If Nominal GDP (the numerator) decreases and the GDP Deflator (the denominator) increases, the resulting Real GDP must decrease. Intuitively, if the total value of sales (Nominal GDP) went down even while prices were rising, the actual quantity of goods sold (Real GDP) must have fallen significantly.

Exercise 3: Calculation Review

To consolidate your understanding of the calculation process, this video provides another clear, step-by-step example using a simple table of data. This format is very useful for organizing your work when solving problems.

Conclusion

In this lesson, we made a crucial distinction between nominal and real measures of economic output. This is a foundational concept for understanding macroeconomic trends and performance.

Key Takeaways:

• Nominal GDP is calculated using current market prices and can be distorted by inflation.
• Real GDP is calculated using constant base-year prices, providing a true measure of changes in the quantity of production.
• The GDP Deflator is a price index calculated as (Nominal GDP / Real GDP) * 100. It measures the overall price level of an economy relative to a base year.
• The inflation rate can be measured as the percentage change in the GDP deflator.

Preview of the Next Lesson:

The GDP deflator is a broad measure of inflation because it includes the prices of all goods and services produced in an economy (consumption, investment, government spending, and exports). However, it's not the only measure of inflation. In our next lesson, we will introduce the Consumer Price Index (CPI), which focuses specifically on the prices of goods and services bought by a typical household. We will learn how to calculate it and, importantly, distinguish it from the GDP deflator.