Learning Objectives 1

By the end of this section, you will be able to:

• Contrast nominal GDP and real GDP
• Explain GDP deflator
• Calculate real GDP based on nominal GDP values

When examining economic statistics, there is a crucial distinction worth emphasizing. The distinction is between nominal and real measurements, which refer to whether or not inflation has distorted a given statistic. Looking at economic statistics without considering inflation is like looking through a pair of binoculars and trying to guess how close something is: unless you know how strong the lenses are, you cannot guess the distance very accurately. Similarly, if you do not know the inflation rate, it is difficult to figure out if a rise in GDP is due mainly to a rise in the overall level of prices or to a rise in quantities of goods produced. Thenominal valueof any economic statistic means that we measure the statistic in terms of actual prices that exist at the time. Thereal valuerefers to the same statistic after it has been adjusted for inflation. Generally, it is the real value that is more important.

Converting Nominal to Real GDP

Table 6.5shows U.S. GDP at five-year intervals since 1960 in nominal dollars; that is, GDP measured using the actual market prices prevailing in each stated year.Figure 6.7also reflects this data in a graph.

Year	Nominal GDP (billions of dollars)	GDP Deflator (2005 = 100)
1960	543.3	19.0
1965	743.7	20.3
1970	1,075.9	24.8
1975	1,688.9	34.1
1980	2,862.5	48.3
1985	4,346.7	62.3
1990	5,979.6	72.7
1995	7,664.0	81.7
2000	10,289.7	89.0
2005	13,095.4	100.0
2010	14,958.3	110.0

Table6.5U.S. Nominal GDP and the GDP Deflator(Source: www.bea.gov)

Figure6.7U.S. Nominal GDP, 1960-2010Nominal GDP values have risen exponentially from 1960 through 2010, according to the BEA.

If an unwary analyst compared nominal GDP in 1960 to nominal GDP in 2010, it might appear that national output had risen by a factor of more than twenty-seven over this time (that is, GDP of $14,958 billion in 2010 divided by GDP of $543 billion in 1960 = 27.5). This conclusion would be highly misleading. Recall that we define nominal GDP as the quantity of every final good or service produced multiplied by the price at which it was sold, summed up for all goods and services. In order to see how much production has actually increased, we need to extract the effects of higher prices on nominal GDP. We can easily accomplish this using the GDP deflator.

TheGDP deflatoris a price index measuring the average prices of all final goods and services included in the economy. We explore price indices in detail and how we compute them inInflation, but this definition will do in the context of this chapter.Table 6.5provides the GDP deflator data andFigure 6.8shows it graphically.

Figure6.8U.S. GDP Deflator, 1960-2010Much like nominal GDP, the GDP deflator has risen exponentially from 1960 through 2010. (Source: BEA)

Figure 6.8shows that the price level has risen dramatically since 1960. The price level in 2010 was almost six times higher than in 1960 (the deflator for 2010 was 110 versus a level of 19 in 1960). Clearly, much of the growth in nominal GDP was due to inflation, not an actual change in the quantity of goods and services produced, in other words, not in real GDP. Recall that nominal GDP can rise for two reasons: an increase in output, and/or an increase in prices. What is needed is to extract the increase in prices from nominal GDP so as to measure only changes in output. After all, the dollars used to measure nominal GDP in 1960 are worth more than the inflated dollars of 1990and the price index tells exactly how much more. This adjustment is easy to do if you understand that nominal measurements are in value terms, where

ValueNominalGDP==PriceQuantityorGDPDeflatorRealGDPValue=PriceQuantityorNominalGDP=GDPDeflatorRealGDP

Let's look at an example at the micro level. Suppose the t-shirt company, Coolshirts, sells 10 t-shirts at a price of $9 each.

Coolshirt'snominalrevenuefromsales===PriceQuantity$910$90Coolshirt'snominalrevenuefromsales=PriceQuantity=$910=$90

Then,

Coolshirt'srealincome===NominalrevenuePrice$90$910Coolshirt'srealincome=NominalrevenuePrice=$90$9=10

In other words, when we compute "real" measurements we are trying to obtain actual quantities, in this case, 10 t-shirts.

With GDP, it is just a tiny bit more complicated. We start with the same formula as above:

RealGDP=NominalGDPPriceIndexRealGDP=NominalGDPPriceIndex

For reasons that we will explain in more detail below, mathematically, a price index is a two-digit decimal number like 1.00 or 0.85 or 1.25. Because some people have trouble working with decimals, when the price index is published, it has traditionally been multiplied by 100 to get integer numbers like 100, 85, or 125. What this means is that when we "deflate" nominal figures to get real figures (by dividing the nominal by the price index). We also need to remember to divide the published price index by 100 to make the math work. Thus, the formula becomes:

RealGDP=NominalGDPPriceIndex/100RealGDP=NominalGDPPriceIndex/100

Now read the following Work It Out feature for more practice calculating real GDP.

WORK IT OUT

Computing GDP

It is possible to use the data inTable 6.5to compute real GDP.

Step 1. Look atTable 6.5, to see that, in 1960, nominal GDP was $543.3 billion and the price index (GDP deflator) was 19.0.

Step 2. To calculate the real GDP in 1960, use the formula:

RealGDP===NominalGDPPriceIndex/100$543.3billion19/100$2,859.5billionRealGDP=NominalGDPPriceIndex/100=$543.3billion19/100=$2,859.5billion

We'll do this in two parts to make it clear. First adjust the price index: 19 divided by 100 = 0.19. Then divide into nominal GDP: $543.3 billion / 0.19 = $2,859.5 billion.

Step 3. Use the same formula to calculate the real GDP in 1965.

RealGDP===NominalGDPPriceIndex/100$743.7billion20.3/100$3,663.5billionRealGDP=NominalGDPPriceIndex/100=$743.7billion20.3/100=$3,663.5billion

Step 4. Continue using this formula to calculate all of the real GDP values from 1960 through 2010. The calculations and the results are inTable 6.6.

Year	Nominal GDP (billions of dollars)	GDP Deflator (2005 = 100)	Calculations	Real GDP (billions of 2005 dollars)
1960	543.3	19.0	543.3 / (19.0/100)	2859.5
1965	743.7	20.3	743.7 / (20.3/100)	3663.5
1970	1075.9	24.8	1,075.9 / (24.8/100)	4338.3
1975	1688.9	34.1	1,688.9 / (34.1/100)	4952.8
1980	2862.5	48.3	2,862.5 / (48.3/100)	5926.5
1985	4346.7	62.3	4,346.7 / (62.3/100)	6977.0
1990	5979.6	72.7	5,979.6 / (72.7/100)	8225.0
1995	7664.0	82.0	7,664 / (82.0/100)	9346.3
2000	10289.7	89.0	10,289.7 / (89.0/100)	11561.5
2005	13095.4	100.0	13,095.4 / (100.0/100)	13095.4
2010	14958.3	110.0	14,958.3 / (110.0/100)	13598.5

Table6.6Converting Nominal to Real GDP(Source: Bureau of Economic Analysis, www.bea.gov)

There are a couple things to notice here. Whenever you compute a real statistic, one year (or period) plays a special role. It is called the base year (or base period). The base year is the year whose prices we use to compute the real statistic. When we calculate real GDP, for example, we take the quantities of goods and services produced in each year (for example, 1960 or 1973) and multiply them by their prices in the base year (in this case, 2005), so we get a measure of GDP that uses prices that do not change from year to year. That is why real GDP is labeled "Constant Dollars" or, in this example, "2005 Dollars," which means that real GDP is constructed using prices that existed in 2005. While the example here uses 2005 as the base year, more generally, you can use any year as the base year. The formula is:

GDPdeflator=NominalGDPRealGDP100GDPdeflator=NominalGDPRealGDP100

Rearranging the formula and using the data from 2005:

RealGDP===NominalGDPPriceIndex/100$13,095.4billion100/100$13,095.4billionRealGDP=NominalGDPPriceIndex/100=$13,095.4billion100/100=$13,095.4billion

Comparing real GDP and nominal GDP for 2005, you see they are the same. This is no accident. It is because we have chosen 2005 as the "base year" in this example. Since the price index in the base year always has a value of 100 (by definition), nominal and real GDP are always the same in the base year.

Look at the data for 2010.

RealGDP===NominalGDPPriceIndex/100$14,958.3billion110/100$13,598.5billionRealGDP=NominalGDPPriceIndex/100=$14,958.3billion110/100=$13,598.5billion

Use this data to make another observation: As long as inflation is positive, meaning prices increase on average from year to year, real GDP should be less than nominal GDP in any year after the base year. The reason for this should be clear: The value of nominal GDP is "inflated" by inflation. Similarly, as long as inflation is positive, real GDP should be greater than nominal GDP in any year before the base year.

Figure 6.9shows the U.S. nominal andreal GDPsince 1960. Because 2005 is the base year, the nominal and real values are exactly the same in that year. However, over time, the rise in nominal GDP looks much larger than the rise in real GDP (that is, thenominal GDPline rises more steeply than the real GDP line), because the presence of inflation, especially in the 1970s exaggerates the rise in nominal GDP.

Figure6.9U.S. Nominal and Real GDP, 1960-2012The red line measures U.S. GDP in nominal dollars. The black line measures U.S. GDP in real dollars, where all dollar values are converted to 2005 dollars. Since we express real GDP in 2005 dollars, the two lines cross in 2005. However, real GDP will appear higher than nominal GDP in the years before 2005, because dollars were worth less in 2005 than in previous years. Conversely, real GDP will appear lower in the years after 2005, because dollars were worth more in 2005 than in later years.

Let's return to the question that we posed originally: How much did GDP increase in real terms? What was the real GDP growth rate from 1960 to 2010? To find the real growth rate, we apply the formula for percentage change:

2010realGDP-1960realGDP1960realGDP10013,598.5-2,859.52,859.5100==%change376%2010realGDP-1960realGDP1960realGDP100=%change13,598.5-2,859.52,859.5100=376%

In other words, the U.S. economy has increased real production of goods and services by nearly a factor of four since 1960. Of course, that understates the material improvement since it fails to capture improvements in the quality of products and the invention of new products.

There is a quicker way to answer this question approximately, using another math trick. Because:

Nominal%changeinNominal%changeinQuantity==OR=PriceQuantity%changeinPrice+%changeinQuantity%changeinNominal-%changeinPriceNominal=PriceQuantity%changeinNominal=%changeinPrice+%changeinQuantityOR%changeinQuantity=%changeinNominal-%changeinPrice

Therefore, real GDP growth rate (% change in quantity) equals the growth rate in nominal GDP (% change in value) minus the inflation rate (% change in price).

Note that using this equation provides an approximation for small changes in the levels. For more accurate measures, one should use the first formula.

Learning Objectives 2

By the end of this section, you will be able to:

• Explain recessions, depressions, peaks, and troughs
• Evaluate the importance of tracking real GDP over time

When news reports indicate that "the economy grew 1.2% in the first quarter," the reports are referring to the percentage change in real GDP. By convention, governments report GDP growth is at an annualized rate: Whatever the calculated growth in real GDP was for the quarter, we multiply it by four when it is reported as if the economy were growing at that rate for a full year.

Figure6.10U.S. GDP, 1900-2016Real GDP in the United States in 2016 (in 2009 dollars) was about $16.7 trillion. After adjusting to remove the effects of inflation, this represents a roughly 20-fold increase in the economy's production of goods and services since the start of the twentieth century. (Source: bea.gov)

Figure 6.10shows the pattern of U.S. real GDP since 1900. Short term declines have regularly interrupted the generally upward long-term path of GDP. We call a significant decline in real GDP arecession. We call an especially lengthy and deep recession adepression. The severe drop in GDP that occurred during the 1930sGreat Depressionis clearly visible in the figure, as is the 2008-2009Great Recession.

Real GDP is important because it is highly correlated with other measures of economic activity, like employment and unemployment. When real GDP rises, so does employment.

The most significant human problem associated with recessions (and their larger, uglier cousins, depressions) is that a slowdown in production means that firms need to lay off or fire some of their workers. Losing a job imposes painful financial and personal costs on workers, and often on their extended families as well. In addition, even those who keep their jobs are likely to find that wage raises are scanty at bestor their employers may ask them to take pay cuts.

Table 6.7lists the pattern of recessions and expansions in the U.S. economy since 1900. We call the highest point of the economy, before the recession begins, thepeak. Conversely, the lowest point of a recession, before a recovery begins, is thetrough. Thus, a recession lasts from peak to trough, and an economic upswing runs from trough to peak. We call the economy's movement from peak to trough and trough to peak thebusiness cycle. It is intriguing to notice that the three longest trough-to-peak expansions of the twentieth century have happened since 1960. The most recent recession started in December 2007 and ended formally in June 2009. This was the most severe recession since the 1930s Great Depression. The ongoing expansion since the June 2009 trough will also be quite long, comparatively, having already reached 90 months at the end of 2016.

Trough	Peak	Months of Contraction	Months of Expansion
December 1900	September 1902	18	21
August 1904	May 1907	23	33
June 1908	January 1910	13	19
January 1912	January 1913	24	12
December 1914	August 1918	23	44
March 1919	January 1920	7	10
July 1921	May 1923	18	22
July 1924	October 1926	14	27
November 1927	August 1929	23	21
March 1933	May 1937	43	50
June 1938	February 1945	13	80
October 1945	November 1948	8	37
October 1949	July 1953	11	45
May 1954	August 1957	10	39
April 1958	April 1960	8	24
February 1961	December 1969	10	106
November 1970	November 1973	11	36
March 1975	January 1980	16	58
July 1980	July 1981	6	12
November 1982	July 1990	16	92
March 1991	March 2001	8	120
November 2001	December 2007	8	73

Table6.7U.S. Business Cycles since 1900(Source: http://www.nber.org/cycles/main.html)

A private think tank, theNational Bureau of Economic Research (NBER), tracks business cycles for the U.S. economy. However, the effects of a severe recession often linger after the official ending date assigned by the NBER.

please I need a journal entry for these articles.

no just I need a summary