Independent University, Bangladesh

Assignment
ECN 201
Submitted by:
Name Faizul Kabir

Submitted to
Dr Shibly Noman Khan

Submission date: 10/11/2010

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Real GDP and Nominal GDP
Nominal GDP measures the value of output during a given year using the prices
prevailing during that year. Over time, the general level of prices rise due to inflation,
leading to an increase in nominal GDP even if the volume of goods and services
produced is unchanged.

Real GDP measures the value of output in two or more different years by valuing the
goods and services adjusted for inflation. For example, if both the "nominal GDP" and
price level doubled between 1995 and 2005, the "real GDP " would remain the same. For
year over year GDP growth, "real GDP" is usually used as it gives a more accurate view
of the economy.

[edit] Relation between Real GDP and Nominal GDP

Nominal GDP is calculated using current prices whereas real GDP uses constant prices.
The difference between the nominal GDP and real GDP is due to the inflation rate in
market. The relationship between inflation, real GDP and nominal GDP is explained by
Fisher Equation.

Real GDP = Nominal GDP - Inflation

A simple example:

Our simplistic economy only produces apples and pears. The price for an apple is $2 in
2000, whereas the price for a pear is $3. Same year we produce 100 apples and 50 pears.
In 2005, because of the inflation the price for an apple goes up to $3, whereas the price
for a pear is $4 at the same production levels.

The nominal GDP in 2000 is $350 and the nominal GDP in 2005 is $500. However real
GDP did not change, because real GDP only changes with the changing production level
and therefore is a better size measure for economy.

Why Measure Final Goods Only?

Why does GDP only measure final goods—goods sold to their ultimate users? Why not
include intermediate goods—goods that are an input in the production of other goods—
as well? The answer is simple: we must count only final goods in order to avoid double
counting. For example, if we measured the value of the seed that became the wheat plus
the wheat that became the flour plus the flour that became the bread plus the bread, we
would be overstating the total value of output, because the final good—in this case, bread
—includes in its price the value of all intermediate goods that went into its production.

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Why We Need Real GDP—When nominal GDP figures are compared between different
years, you cannot determine whether the increase in GDP came from an increase in the
price level or an increase in output. Real GDP is GDP adjusted for changes in the price
level—that is, GDP measured in constant dollars, rather than in current dollars.

Measuring the Standard of Living

Economists want to be able to make statements that compare the standard of living
between different countries or between different time periods. This is quite tricky. As
we have just observed, people enjoy a very different mix of products and services at
different points in time. In fact, a likely reason that DeLong seized on the example of
flour is that flour is one of the few products that we buy today that we can picture being
purchased 500 years ago.
Economists estimate the average standard of living in a particular year in a particular
country by taking the total value of goods and services produced in that country in that
year and dividing by population. The total value of goods and services produced is called
real Gross Domestic Product, or real GDP. The ratio of GDP to population is called
GDP per capita. GDP per capita is the usual measure of the standard of living.
GDP is usually measured in dollars. Although the Japanese might measure their GDP in
yen, we would convert their GDP to dollars in order to compare it to ours. We can do
such a conversion by using the yen/dollar exchange rate, the rate at which you can trade
yen for dollars.
When we compare GDP across time, we want to adjust for inflation, which is a general
change in prices. If we produced 100 bags of flour at a price of $0.50 each last year, and
this year we produce 100 bags of flour at a price of $1.00, how much did our GDP go up?
If you said that our GDP doubled from $50 to $100, then you were calculating nominal
GDP, which is the total dollar value of goods and services. Nominal GDP is a
misleading measure of the standard of living. Because we produced the same 100 bags of
flour each year, we would say that real GDP--the physical production of goods--was
exactly the same as last year.
To arrive at real GDP, we adjust nominal GDP for price changes. We pick one year as a
base year, and then we measure price changes relative to that base year. If last year was
the base year, then real GDP in the base year was $50. Since the price of flour went up
from $0.50 to $1.00, we say that the price level doubled this year, so that our GDP price
deflator is 2.0. We can divide nominal GDP in any given year by that year’s GDP
deflator to arrive at real GDP. Thus, we divide $100 by 2.0 to obtain the correct $50
figure for real GDP.
The following is an important relationship:
Real GDP = Nominal GDP/GDP Deflator
In general, an increase in nominal GDP has two components. One component is the
increase in real GDP, which raises the average standard of living. The other component
is average inflation, which does not raise the average standard of living. In an economy
with many goods and services, the increase in the implicit GDP deflator from one year to

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the next is a measure of average inflation. Inflation is a general increase in the prices of
goods and services.
The foregoing relationship can be summarized as:
growth in nominal GDP = growth in real GDP plus growth in inflation

The average standard of living in a country is defined as its real GDP divided by
population, or real GDP per capita. This measure of the standard of living is closely
related to labor productivity, which is defined as real GDP divided by the total number of
hours worked. By definition,

Standard of living = real GDP/population

Labor productivity = real GDP/hours worked

Then algebraically we have

real GDP/population = (real GDP/hours worked) (hours worked/population)

We can call the ratio of hours worked to population the employment ratio. Therefore, the
standard of living is equal to productivity multiplied by the employment ratio. Thus, we
can raise the standard of living by raising the employment ratio. However, that is an
artifact of the way that GDP only measures goods bought and sold in the market. It does
not include leisure, and it does not include household work, as when a parent stays home
to take care of the children or when homeowners repaint their house themselves.

Other things equal, an increase in the employment ratio ought to be regarded as a

reduction in the quality of life. It means that people are working harder. Thus, even
though the ratio of output to population is commonly used to measure the standard of
living, a good argument can be made that productivity (the ratio of output to hours
worked) is more closely related to the real quality of life. Thus, one could say that it is
more meaningful to compare labor productivity across time and across countries than to
compare the standard of living.

On the other hand, the employment ratio can change because of demographics. If there is
an increase in either the very old or the very young, that will mean more people for the
working-age population to support. This will show up as a low employment ratio, and
the reduction it entails for the standard of living is real.

The magnitudes output, hours worked, and population tend to grow geometrically. That
is, over a period of several years, the average annual percentage increase is more likely to
be constant than the average annual numerical increase. Suppose that you were to
observe population each year obeying this sequence: 100 million, 103 million, 106.09
million, 109.27 million, 112.55 million, and so on. You could describe the average
increase arithmetically as 3.14 million per year or geometrically as 3.0 percent per year.
However, the 3.0 percent per year figure is more accurate.

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