Table 2 shows some data for an economy that produces only two goods: hot dogs and hamburgers. The table shows the quantities of the two goods produced and their prices in the years 2005, 2006, and 2007. To compute total spending in this economy, we would multiply the quantities of hot dogs and hamburgers by their prices, In the year 2005, 100 hot dogs are sold at a price of $1 per hot dog, so expenditure on hot dogs equals $100. In the same year, 50 hamburgers are sold for $2 per hamburger, so expenditure on .
TABLE 2. Real and Nominal GDP
This table shows how to. calculate real GDP,nominal GDP,and the GDP deflator for a hypothetical economy that produces only hot dogs and hamburgers.
hamburgers also equals $}OO.Total expenditure in the economy-the sum of expenditure on hot dogs and expenditure on hamburgers-is $200. This amount, the production of goods and services valued at current prices, is called nominal GDP. The table shows the calculation of nominal GDP for these three years. Total spending rises from $200 in 2005 to $600 in 2006 and then to $1,200 in 2007. Part of this rise is attributable to the increase in the quantities of hot dogs and hamburgers, and part is attributable to the increase in the prices of hot dogs and hamburgers To obtain a measure of the amount produced that is not affected by changes in prices, we use real GDP which is the production of goods and services valued at constant prices. We calculate real GDP by first
choosing one year as a base year. We then use the prices of hot dogs and hamburgers in the base year to compute the value of goods and services in all of the years. In other words, the prices in the base year provide the basis for comparing quantities in different years. Suppose that we choose 2005 to be the base year in our example. We can then use the prices of hot dogs and hamburger -2005 to compute the value of goods and services produced in 2005, 2006, and 2007. Table 2 shows these calculations. To compute real GDP for 2005, we use the prices of hot dogs and hamburgers in 2005 (the base year) and the quantities of hot dogs and hamburgers produced in 2005. (Thus, for the base year, real GDP always equals nominal GDP.) To compute real GDP for 2006, we use the prices of hot dogs and hamburgers in 2005 (the base year) and the quantities of hot dogs and hamburgers produced in 2006. Similarly, to compute real GDP for 2007, we use the prices in 2005 and the quantities in 2007. When we find that real GDP has risen from $200 in 2005 to $350 in 2006 and then to $500 in 2007, we know that the increase is attributable to an increase in the quantities produced because the prices are being held fixed at base-year levels. To sum up: Nominal GDP uses current prices to place a value on the economy s production of goods and services. Real GDP uses constant base-year-prices to place a value on the economy’s production of goods and services. Because real GDP is not affected by changes in prices, changes in real GDP reflect only changes in the amounts being produced. Thus, real GDP is a measure of the economy’s production of goods and services. Our goal in computing GDP is to gauge how well the overall economy is performing. Because real GDP measures the economy’s production of goods and services, it reflects the economy’s ability to satisfy people’s needs and desires. Thus, real GDP is a better gauge of economic well-being than is nominal GDP. When
economists talk about the economy’s GDP, they usually mean real GDP rather than nominal GDP. And when they talk about growth in in the economy, they measure that growth as the percentage change in real GDP from one period to another.
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