WEBVTT

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In the last video, we studied
a super simplified economy

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that only sold one
good or service.

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But now let's think about things
a little bit more generally,

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or a little bit more
complex economies.

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And let's say that in
year one economists

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have determined that the
level of prices of the goods

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and services produced
in that economy is 100.

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So they've essentially
just multiplied

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and divided by
the right numbers,

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so that their index
that they generate just

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says that that is 100.

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And they do this so that
they can measure the prices

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in other years
relative to year one.

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So let's say in year
two, using their index,

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they realize that
prices are now 110.

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Now, this is not a
simple thing to do.

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This would have been
a very simple thing

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to do if there was only one
good or service in the economy,

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like in our last
example, apples.

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You could have just taken
the price of apples.

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It went from $0.50 to $0.55.

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In the real world, this is
not a simple thing to do.

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You have a gazillion
goods and services.

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Some prices go up.

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Some prices to go down.

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The quantities of the
goods and services change.

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In fact, there might
be goods and services

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that were offered
in year one that

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don't exist anymore in year two.

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And there are goods and
services in year two

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that didn't exist in year one.

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But for the sake of
this video, let's just

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assume that economists
are able to say this.

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If you call the general level
of prices 100 in year one,

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it's now 110.

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Or another way to think
about it is things

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have gotten 10% more expensive.

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Now, assuming that we know this
relationship-- and once again,

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it's not an easy
thing to figure out,

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and it actually turns out
there's no perfect way

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to do this-- how
can we figure out

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a relationship between
real GDP and nominal GDP?

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And remember, whenever
we talk about real GDP--

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so we're going to talk
about real GDP in year two--

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whenever you talk
about real GDP,

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you're talking
about GDP in terms

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of the prices in some base year.

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So in this example, we'll
think about real GDP

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in year two in terms
of a year one dollars.

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So whatever were the
goods and services

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that were produced in year two,
we're going to think about,

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well, what if they were at the
same prices as in year one?

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And that will give us
the real GDP in year two.

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So one way to think about
it is really just a ratio.

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So let me write nominal GDP.

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So this is GDP in
year two, measured

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in year two dollars,
divided by-- I

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guess we could call
this a proportion,

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really-- divided by the
real GDP in year two.

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And this is measured
in year one dollars.

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Well, that's going
to be the same thing

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as the ratio of the prices
between year two and year one.

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This is going to be the ratio
of-- we use this indicator

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right over here-- 110 to 100.

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And I want you to just sit and
think about this for a second.

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It's just saying, look, these
are measuring the same goods

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and services.

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The real GDP is measuring
them in year one prices.

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The nominal GDP is measuring
them in year two prices.

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So if things got
10% more expensive

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between year one and
year two, the nominal GDP

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should be 10% larger
than real GDP.

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We should have the
exact same ratios.

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And now we can manipulate this
thing using any type of algebra

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that we want.

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For example, we could
say, well, nominal GDP--

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And I'll just write nominal now.

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This is where I
kind of specified

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exactly what we're
talking about.

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This is a nominal
GDP of year two.

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So now we could say
nominal GDP is equal

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to-- we can multiply both
sides times the real GDP--

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is equal to 110 over
100 times the real GDP.

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And remember, this is
nominal GDP in year two.

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This is real GDP in year two,
measured in year one dollars.

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Or we can divide both
sides of this equation

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by this 110 over 100.

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And then we get nominal
GDP in year two divided

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by 110 over 100 is equal
to real GDP in year two.

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This is nominal GDP in year two.

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And writing it this
way kind of feels

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like you're taking your
nominal GDP in year two,

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and there's been
a general increase

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in the level of prices.

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That's called price inflation.

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We see that right over here.

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And now we're deflating
it to get real GDP.

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We're dividing it by
the ratio of the prices.

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We're dividing it essentially by
how much the prices have grown,

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or I guess you could say the
ratio between the year two

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prices and the year one prices.

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So this quantity right
over here is 1.1.

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So another way you
could think about it,

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we're deflating the
nominal GDP in year two

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to get the real GDP in year two.

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We're getting it in, remember,
this is in year one prices.

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And because of that, this
number right over here

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is referred to as a deflator.

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This is our GDP deflator.

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You pick a base here, in
this case, it was year one.

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That base year could
have been 1985.

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It could've been 2006.

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Who knows what it could be.

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It could be anything.

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Your GDP deflator is going to
be relative to that base year.

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It's going to say, well,
if that base here was 100,

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your deflator's going to
say how much things are now

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in this year.

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And you can even go
backwards in time.

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Year zero, the deflator
might have been 85,

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because maybe things
have gotten cheaper.

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Or you could actually
had prices go down.

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You could have
actually had deflation.

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So maybe in year two your
deflator would be at 98.

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But the reason why
it's called a deflator

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is because generally you have
inflation as time goes on,

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and generally you're going to
be deflating your nominal GDP.

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You're going to be dividing it
by a value greater than one.

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It's going to be something
over 100 divided by 100,

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which is your base year,
to get your real GDP.