Unit 2 · Topic 2.6

2.6 Real v. Nominal GDP

Nominal GDP uses current prices, so it rises when output rises or when prices rise. Real GDP uses constant base-year prices, so it rises only when the economy actually produces more. The GDP deflator connects the two and is another way to measure the price level.

Key terms

nominal GDP
real GDP
base year
GDP deflator
constant prices

Two ways to value the same output

Nominal GDP measures how much is spent on final output, valued at the prices of the year it was produced. If prices double and output stays the same, nominal GDP doubles.

Real GDP measures how much is actually produced. It values each year's output at the prices of a chosen base year. Since the prices are held fixed, only changes in the amounts produced can move it. If prices double and output stays the same, real GDP stays the same.

In the base year, nominal GDP and real GDP are equal, because current prices and base-year prices are the same.

The GDP deflator

The deflator is a price index for everything included in GDP. A deflator of 125 means prices of domestic output are 25% above the base year. The percent change in the deflator from one year to the next is an inflation rate, just like with the CPI.

The deflator and the CPI differ a little. The CPI prices a fixed basket of consumer goods (including imports), while the deflator covers all final goods and services produced in the country, and its mix changes as output changes.

GDP deflator = (nominal GDP ÷ real GDP) × 100
Real GDP = nominal GDP ÷ (GDP deflator ÷ 100)
Nominal GDP = real GDP × (GDP deflator ÷ 100)

Growth rates

Growth rate of real GDP = (this year's real GDP − last year's real GDP) ÷ last year's real GDP × 100. This is the number people mean when they say "the economy grew 2% last year."

Nominal GDP growth is roughly real GDP growth plus inflation, so nominal growth can look strong even when real output is flat. If nominal GDP rises 3% in a year when the price level rises 4%, real GDP actually fell by about 1%.

That's why economists track real GDP to judge whether the economy is in an expansion or a recession (2.7), and why the AD–AS model in Unit 3 puts real GDP, not nominal GDP, on the horizontal axis.

Valuing output at one fixed base year's prices can overstate real growth over long periods, so official statistics use more advanced methods (chained prices). You won't need to calculate those; base-year prices are what the exam uses.

Worked examples

Try each one yourself first, then open the solution.

Example 1Calculator allowed
Real GDP, nominal GDP and the deflator from scratch
An economy makes only burgers and shirts. Year 1 (the base year): 100 burgers at $4 and 50 shirts at $20. Year 2: 120 burgers at $5 and 60 shirts at $25. Find (a) nominal GDP in each year, (b) real GDP in Year 2, (c) the GDP deflator in Year 2, and (d) the growth rate of real GDP.
Show the solutionHide the solution
1. Step 1: (a) Year 1 nominal = 100 × $4 + 50 × $20 = $400 + $1,000 = $1,400. Year 2 nominal = 120 × $5 + 60 × $25 = $600 + $1,500 = $2,100.
2. Step 2: (b) Year 2 real GDP uses Year 2 quantities at Year 1 prices: 120 × $4 + 60 × $20 = $480 + $1,200 = $1,680. Year 1 real GDP equals its nominal GDP, $1,400, because it's the base year.
3. Step 3: (c) Deflator = 2,100 ÷ 1,680 × 100 = 125.
4. Step 4: (d) Real growth = (1,680 − 1,400) ÷ 1,400 × 100 = 20%. Nominal GDP grew 50%, but most of that was higher prices.
Answer: (a) $1,400 and $2,100. (b) $1,680. (c) 125. (d) Real GDP grew 20%.
Example 2Calculator allowed
Deflating nominal GDP (classic trap)
Nominal GDP is $24 trillion and the GDP deflator is 120. What is real GDP?
Show the solutionHide the solution
1. Step 1: Real GDP = nominal GDP ÷ (deflator ÷ 100) = $24 trillion ÷ 1.20 = $20 trillion.
2. Step 2: Sense check: a deflator above 100 means prices are higher than in the base year, so real GDP must be smaller than nominal GDP.
3. Step 3: The trap is multiplying ($24 trillion × 1.20 = $28.8 trillion), which makes real GDP bigger than nominal.
Answer: Real GDP = $20 trillion.

Common mistakes

Using current-year prices for real GDP. Real GDP always uses base-year prices.
Concluding that output grew because nominal GDP grew. Check real GDP; the rise may be all inflation.
Multiplying by the deflator to get real GDP. Divide by (deflator ÷ 100).
Forgetting that in the base year, real GDP = nominal GDP and the deflator = 100.

On the exam

Expect to calculate real GDP or the deflator from a table, or to say whether a rise in nominal GDP came from more output or higher prices.
A quick check that catches most errors: when the price level is above the base year (index over 100), real GDP is less than nominal GDP.

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