Nominal GDP Versus Real GDP

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In an earlier article we measured Gross Domestic Product (GDP) using two methods (approaches)—expenditure method and income method.  The result in either case arrives at the GDP estimate in current prices or dollars.  This is known as the Nominal GDP.  As prices charge over time so does the value of the dollar.  For example, if the nominal GDP increased by 5 percent in a given year but so did the average price level, then it means there was in fact no real increase in GDP.  Thus, we need to convert the Nominal GDP into Real GDP taking into account the rate of inflation—increase in the price level.

Real GDP:

Real GDP is arrived at for changes in price level by measuring the changes which occurred in output/production.  The process of adjusting nominal GDP for price changes is called deflating GDP.   A price index compares the value of GDP of a given year with the base year or the reference year.  The base year is a point of reference to which prices in other years are compared.  The price index is obtained by dividing each year’s prices by the price in the base year and multiplying it by 100.

Consumer Price Index (CPI):

The consumer price index (CPI) is commonly used to measure changes over time in the cost of buying a “market basket” of goods and services by an average family.  The federal government uses the years 1982-84 as the base period for arriving at the CPI for a market basket of 400 goods and services in eight major categories.  The prices of these items are collected from 23,000 retailers around the country.

However, CPI is criticized for:

v       Taking long time to incorporate the shift in consumer tastes.

v       Not realizing the shift of consumers for shopping at discount stores.

v       Ignoring consumer substituting less expensive goods for expensive ones.

v       Assuming that the quality of market basket remains unchanged over time.

and thus overestimating the rate of inflation by about one percent.  Since wage agreements, social security and welfare payment are tied with the CPI costing businesses and government hundreds of billions of dollars.

The rate of inflations in the United States in year 200 was 1.58 percent--one of the lowest in recent years. After rising to 3.29 percent in 2005, it fell to 2.85 percent in 2007.  However, with recent rises in energy and food prices, the annualized rate for year 2008 is at present 5.6 percent.  Unfortunately the rate unemployment also hit 5.7 in July 2008—highest since 1990.  The combination of high inflation and high unemployment rates is known as “Stagflation” –a term that was coined to describe a similar situation in the 1970s.

GDP Price Index—GDP Deflator:

The GDP price index, as apposed to CPI index, measures the average price level of all good and services included in the GDP estimates.  Also the base year for the GDP price index is year 2000.  The closer the year in question is to the base year, the more accurate is the measure of real GDP.  That is why the GDP price index is shifted frequently and called the GDP deflator to reflect the change in price level of the goods and services produced.

GDP Deflator = Current year GDP at current year prices divided by Current year GDP at base year prices.  Since the base year deflator is 100, we multiply it by 100 to express it in percent.

GDP deflator for 2007=$13,807 Billion/$11,524 Billion = 1.198 or 1.198 x100 = 119.8%.

The nominal GDP for the year 2007 was $13,807 billion.  To covert it into real GDP, we divided it by 1.198 and get $11,524 billion. 

Nominal Per Capita GDP = Nominal GDP divided by

                                           population  

                                       = $13807 billion/302 million

                                       = $45,707

Real Per Capita GDP       = Nominal Per capita GDP divided

                                           by the GDP deflator

                                       = $45,707/1.198

                                       = $38.152

The GDP deflator being 100 in year 2000 as the base year (year of reference) rose to 106.41 percent in 2004 and to 119.82 in 2007.

Here is the link for additional data:  http://www.measuringworth.org/usgdp

                                                     

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