When we measure GDP, we use market value or today's prices for goods and services. Suppose that the price of Choco Bars this year is 75 cents, and last year the price was 50 cents. If we produced 100 Choco Bars in each year, the total market value of Choco Bars this year is $75 ($.75 x 100), and the total market value last year was $50 ($.50 x 100). Let's stop and think a minute. Does the difference in the total market value of Choco Bars for the two years reflect a change in production? To answer this question, let's hear from our economist, Mr. Kliesen.
Let's go back to our Choco Bar example. This year the market value is $75. Last year the market value was $50. Does that change in market value reflect a change in production? No, it doesn't. The difference in those two market values is simply due to an increase in the prices. No additional Choco Bars were produced this year.
GDP measured using current prices is called "nominal GDP." When GDP is computed using current prices, price changes make it difficult to determine how much the change in GDP from one year to the next is due to those price changes and how much is the result of a change in production of goods and services. When GDP is adjusted for price changes, it is called "real GDP."
Based on the descriptions of nominal vs. real GDP, see if you can answer the following question:
GDP that has not been adjusted for price changes is referred to as:
Let's try another question:
If prices have risen, and GDP is calculated based on current prices, the change in the size of GDP could be due to the increased prices. To measure the economy's growth from year to year, economists adjust nominal GDP for price changes. To do this, they compute GDP in terms of the dollar prices in a base year. The resulting measurement is known as:
Now we have an exercise that will really test your brain power:
Suppose you are a government statistician and have been asked to report on the GDP of Duoland. Duoland is a small country with an economy that produces only two goods and services—hamburgers and haircuts. Calculate the nominal GDP for Year 2 by multiplying the price by the quantity of each good or service and adding the total production per year in dollars. Notice that nominal GDP for Year 1 has already been calculated.
Price X Quantity = GDP
|Nominal GDP =||$30|
|Nominal GDP =|
|Nominal GDP =||$120|
If you looked at information that stated that GDP in Year 1 was $30 and in Year 2 was $120, you might conclude that the economy produced four times as many goods and services in Year 2 compared with Year 1. But did it? No, it didn't. That means that some of the change in nominal GDP was due to price changes, rather than actual production changes.
To complete your report, which of the following reasons would explain why you use real GDP to compare GDP over time?