The Difference Between Real and Nominal GDP - dummies

The Difference Between Real and Nominal GDP

By Daniel Richards, Manzur Rashid, Peter Antonioni

The assumption (pretense) that underlies gross domestic product (GDP) — that you can think of the economy as just producing one, very multi-purpose good. Why do macroeconomists make this assumption?

The simple answer is that they’d like to talk about “the economy” as parsimoniously as possible. If someone asks about the U.S. production last year, they don’t want to have to say that it’s $2.2 trillion of manufacturing, $3.6 trillion of financial serves, and so on. And they really don’t want to have to say that it’s $155 billion of machinery, $100 billion of air transportation, $1.4 trillion of finance and insurance services, and so forth. That’s too much and too detailed information for anyone to take-in. By the time the list was completed, it would be out of date in any case.

So, they keep it short — just one number that summarizes aggregate production overall. But that requires adding up the sugar, oil, manufacturing, finance services, apples, oranges, and so on, all into one total. And you know from math class that there’s only one way to add up apples and oranges and manufacturing goods and finance services — you need to find a common denominator.

Dollars (or whatever the domestic currency is) are the common denominator. That’s why the U.S. GDP was quoted as $18 trillion. That’s the sum of the final dollar sales (or value added) across all goods and services. It’s easy to add up these magnitudes because they’re all expressed in the same unit of account.

No good deed and few good shortcuts go unpunished, though. Using dollar magnitudes allows you to add everything up easily. But it also introduces a new problem. The U.S. produced about $18 trillion worth of GDP in 2015. Suppose in 2016 the economy experienced a lot of inflation — so much so that the price of everything doubled. And imagine that the total quantity of goods and services produced in 2016 were the same as in 2015 — the same number of apples, oranges, tons of steel, barrels of oil, passengers carried on airlines, and so forth. The question is: What’s GDP in 2016?

Well, because the price of everything doubled and the quantity of goods remained the same, you could argue that GDP is now $36 trillion. And in one sense you’d be right. That is the “value” of everything being produced in 2016. But that doesn’t sound quite right, does it? The economy is producing just as much this year as last year and yet GDP appears to have doubled.

In such a situation economists say that, although nominal GDP has doubled, real GDP has remained unchanged. Here’s the difference:

  • Nominal GDP: Measured using current prices — prices that were current at the time of measurement. 2015 prices in 2015 and 2016 prices in 2016.
  • Real GDP: Measured using constant prices — meaning an arbitrary year is chosen to be the base year, and GDP in all other years is calculated on the basis of prices in the base year.