GDP is an important economic indicator, and it must be understood to be analyzed. In this lesson, you'll learn how price levels impact output and GDP and how real GDP can be calculated.
Gross Domestic Product and Inflation
When economists measure the size of an economy, the most common metric they use is one that reports the total value of all the goods and services produced by workers in that economy. This number is called GDP, or gross domestic product. But just knowing a country's GDP for one time period doesn't tell us a whole lot; we want to be able to compare it to other countries, or even more importantly, compare the same economy to itself last quarter, or last year, or over the last 100 years. Historical trends provide important and valuable economic information.
Before we start analyzing GDP of countries over time, it's important that we make adjustments to ensure that we're comparing apples to apples. There are some fundamental economic tenets that must be considered. The first is that, generally speaking, price levels increase over time. This is what economists call inflation. Inflation is the rate at which prices increase, or said a different way, inflation is the rate at which money loses value. The second important economic principle is that an economy grows when output increases, not just when prices rise. Let's dig into this concept a little more.
Real vs. Nominal
When studying economics, you'll often hear the terms 'real' and 'nominal.' The difference between these terms is important to understand because they are often used to describe the same concept, like gross domestic product, or GDP, but change how that concept is measured. Simply put, a nominal measure is valued in current market prices, while a real measure is adjusted for price fluctuations. Let's look at a very simple example.
Tinyland is a small country that produces one item - Tinyland t-shirts. In 2012, Tinyland produced one million Tinyland t-shirts, and each shirt sold for $10. So in 2012, Tinyland's nominal GDP was $10,000,000 (1 million shirts * $10 per shirt). In 2013, Tinyland again produced 1 million t-shirts, but because of a gold medal in the Olympics, the price of the shirts increased to $12. So in 2013, nominal GDP was $12 million (1 million shirts * $12 per shirt). Based on nominal data, the GDP of Tinyland increased $2 million, or 20%!
GDP growth of 20% would suggest that an economy is booming and expanding. But economic growth means output increased, and did output increase from 2012 to 2013 in Tinyland? No. In both years, one million shirts were produced. So, to have a meaningful comparison between Tinyland's 2012 and 2013 GDP, we need to adjust GDP in one of those years so we are comparing real GDP numbers. We'll talk about how to make that adjustment later in the lesson. For now, just remember: nominal means based on current market value, and real means a measure is adjusted for price fluctuations.
Gross Domestic Product
We touched on GDP earlier, but let's review. Gross domestic product (GDP) is the total value of all goods and services produced. Typically, GDP is reported by quarter or by year, and by country. In our earlier example, Tinyland's 2013 GDP was $12 million - they produced 1 million shirts worth $12 each. Of course, in real life, GDP is much more complicated than that. No country really only produces one item. Think about the thousands, and probably millions, of different items and services that are produced in the U.S. economy. Taken together, they become the nearly $16 trillion 2013 GDP of the United States.
Changes in Price Levels
Did you ever hear a parent or grandparent talk about how, when they were a kid, candy bars cost a nickel? Now that same candy bar costs $1. Why is that? Is that candy bar more valuable than it was 50 years ago? No. Are candy bars bigger now than they were 50 years ago? No. The answer can be found by understanding an important, fundamental economic concept: inflation. Inflation is the rate at which prices increase, or, said another way, the rate at which money loses its value.
It's easy to see the impact of inflation over 50 years, like in our candy bar example. But whether you realize it or not, price levels tend to increase each year at a rate of around 2-3%. That doesn't mean that every item increases in price each year. The inflation rate calculated by the federal government is the weighted average price increase of a predetermined basket of goods and services.
If we are talking about real output and real GDP, why are we talking about inflation? Because remember, GDP - as measured only by current dollars - will increase every year by the inflation rate.
Remember Tinyland, our producer of t-shirts? In our example, price increased by 20% from 2012 to 2013, so when we calculated GDP, we also saw a 20% increase in GDP. But real output, the total value of production as measured by inflation-adjusted dollars, didn't change at all. If we want to see the growth in Tinyland's real GDP, the gross domestic product as measured by inflation-adjusted dollars, we need to adjust 2013's output for the 20% inflation. In our example, that's not that hard to do.
When we understand that prices increase over time, it's easy to see how comparing GDP growth in 2010 to GDP in 1960 isn't really comparing apples to apples. The candy bar your parents bought in 1960 for a nickel added five cents to the GDP, while the $1 candy bar you bought yesterday added $1 to GDP. But, real output, the total value of all output as measured in today's dollars, didn't increase - you still only had one candy bar, just like your grandparents. The only thing that changed was the price, but that change makes a big difference.
So if we really want to see how an economy has grown, we need to compare real output over time. Calculating real output takes the impact of price increases out of GDP, allowing us to compare apples to apples. To do this, we need to know the inflation rate. Once we know the inflation rate, we can easily calculate the GDP deflator: simply 1 + the inflation rate. If the inflation rate was 3%, then the GDP deflator is 1.03.
Remember in our original example, Tinyland had an inflation rate of 20% when the price of their t-shirts went from $10 to $12? That gives us the GDP deflator of 1.2. Now, we can take Tinyland's 2013 GDP of $12 million and adjust it by dividing it by 1.2 - the GDP deflator. That gives us $10 million. Just like we expected, by taking the inflation effect out of the GDP growth, the output of Tinyland stayed flat - $10 million each year. This tells us that the Tinyland economy did not grow in real terms, only in nominal terms.
In closing, let's see how the three concepts we discussed - price levels, GDP, and real output - are all related.
Generally speaking, price levels increase over time. This is called inflation; it's the reason your grandparents bought candy bars for a nickel and they cost you $1. The candy bar isn't 20x bigger or better, but the prices of the ingredients increased, so the price of the candy bar increased as well.
Increases in prices are important to acknowledge when looking at GDP because GDP is based on the market value of goods and services. In 1960, the GDP of the U.S. was $545 billion. In 2013, it was $16 trillion. That sounds like a pretty impressive increase: GDP in 2013 was almost 32 times than it was in 1960! But that's nominal growth, meaning it includes increases in prices.
Between 1960 and 2013, prices increased an average of 3% per year. These increases in prices played a big part in the GDP growth. If we convert the 1960 GDP into 2013 dollars, essentially taking out the impact of inflation and giving us real GDP growth, then based on the 2013 prices, the 1960 GDP was just over $3 trillion. Still, the U.S. economy grew from $3 trillion to $16 trillion in just over 50 years, a very impressive 5 times increase.
After reviewing this lesson, you should have the ability to:
- Define inflation and GDP
- Differentiate between nominal and real growth
- Explain the relationship between price levels, GDP, and real output
- Understand how to calculate nominal and real GDP