A Good Measure to Know

• First, adjusting for inflation. A comparison of real gross domestic product between years identifies changes attributed exclusively to physical production. This makes real gross domestic product a much better indicator of the health and vitality of the economy than nominal gross domestic product.


• Second, tracking business cycles. Real gross domestic product does a better job of picking up business cycles than nominal gross domestic product. Because nominal gross domestic product includes both quantity and price changes, changes in physical production often go unnoticed. Real gross domestic product provides a better indicator of the overall performance of the economy.

Adjusting for Inflation

Real gross domestic product uses CONSTANT market prices to adjust for inflation and price changes.

Suppose, for example, that a good like hot fudge sundaes produced this year are sold this year for $2 each. The current market value is based on this $2 price tag. The CURRENT price is $2. This is the price at which the hot fudge sundaes are exchanged. If 100,000 hot fudge sundaes are sold this year for $2 each, then the current market value of hot fudge sundae production is $200,000. This information is used to calculate nominal gross domestic product--CURRENT production at CURRENT prices.

Knowing the CURRENT market value of CURRENT economic production, or nominal gross domestic product, is quite useful. However, in many cases REAL gross domestic product, CURRENT economic production measured at CONSTANT prices is more useful.

Suppose, for example, that GDP (nominal GDP) this year is 10 percent greater than last year. What does this say about the economy's ability to produce the goods and services that satisfy wants and needs?

• One possibility is that physical production has increased by 10 percent, with no change in prices.


• Another possibility is that prices have increased by 10 percent, with no change in physical production.


• A third possibility is that production and prices have both changed, say a 6 percent increase in production and a 4 percent increase in the prices.


• Yet another possibility is that either production or prices have decreased, say a 4 percent decrease in production with a 14 percent increase in prices.

Now suppose that real GDP this year is 10 percent greater than last year. What does this say about the economy's ability to produce the goods and services that satisfy wants and needs?

• The ONLY possibility is that physical production has increased by 10 percent. The reason is that real GDP IS a measure of physical production and ONLY physical production.

The task readily accomplished by real gross domestic product is a means of comparing changes in economic production from one year to the next. It indicates how the physical production of goods and services, the production used to satisfy wants and needs and lessen the scarcity problem, changes over time.

GDP Price Deflator

Here is an overview of how the GDP price deflator is measured.

• First suppose that real gross domestic product is calculated using 2000 base year prices. This means that 2004 real gross domestic product is estimated using 2000 prices.


• However, nominal gross domestic product for the year 2004 is also estimated. In this case, 2004 nominal gross domestic product is estimated using 2004 prices.


• A comparison between 2004 real gross domestic product and 2004 nominal gross domestic product then indicates how much prices change from 2000 to 2004.


• If 2004 nominal gross domestic product is 5 percent greater than 2004 real gross domestic product, then prices have increased by an average 5 percent from 2000 to 2004.


• By setting the ratio of real and nominal gross domestic product to 100 in the 2000 base year, then the GDP price deflator is equal to 105 in 2004.