Nominal vs. Real GDP

"Are you better off today than you were 4 years ago? What about 40 years ago?"

These sorts of questions invite a different kind of query: what exactly do we mean, when we say “better off?” And more importantly, how do we know if we’re better off or not?

To those questions, there’s one figure that can shed at least a partial light: real GDP.

In the previous video, you learned about how to compute GDP. But what you learned to compute was a very particular kind: the nominal GDP, which isn’t adjusted for inflation, and doesn’t account for increases in the population.

A lack of these controls produces a kind of mirage.

For example, compare the US nominal GDP in 1950. It was roughly $320 billion. Pretty good, right? Now compare that with 2015’s nominal GDP: over $17 trillion.

That’s 55 times bigger than in 1950!

But wait. Prices have also increased since 1950. A loaf of bread, which used to cost a dime, now costs a couple dollars. Think back to how GDP is computed. Do you see how price increases impact GDP?

When prices go up, nominal GDP might go up, even if there hasn’t been any real growth in the production of goods and services. Not to mention, the US population has also increased since 1950.

As we said before: without proper controls in place, even if you know how to compute for nominal GDP, all you get is a mirage.

So, how do you calculate real GDP? That’s what you’ll learn today.

In this video, we’ll walk you through the factors that go into the computation of real GDP.

We’ll show you how to distinguish between nominal GDP, which can balloon via rising prices, and real GDP—a figure built on the production of either more goods and services, or more valuable kinds of them. This way, you’ll learn to distinguish between inflation-driven GDP, and improvement-driven GDP.

Oh, and we’ll also show you a handy little tool named FRED — the Federal Reserve Economic Data website.

FRED will help you study how real GDP has changed over the years. It’ll show you what it looks like during healthy times, and during recessions. FRED will help you answer the question, “If prices hadn’t changed, how much would GDP truly have increased?”

FRED will also show you how to account for population, by helping you compute a key figure: real GDP per capita. Once you learn all this, not only will you see past the the nominal GDP-mirage, but you’ll also get an idea of how to answer our central question:

"Are we better off than we were all those years ago?"

Macroeconomics Course: http://www.mruniversity.com/courses/principles-economics-macroeconomics

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- [Professor Alex Tabarrok] Is the economy growing?
Are people better off today than they were

four years ago? What about 40 years
ago? The GDP statistic can help us to

answer all of these questions. But first,
we do need to make some modifications. As

we discussed in our first video, GDP sums
up the prices of all finished goods and

services. So that means that there are two
ways the GDP can increase. First, prices

can increase. In this case, the GDP number
goes up, but the economy isn't actually

producing more goods and services. It's
inflation which is driving the higher GDP.

The increase in GDP - it might look good on
paper - but it's a mirage, a nominal

increase only. The other way the GDP can
increase is if we DO produce more valuable

goods and services. That could mean simply
more goods and services, or better goods

and services, more highly-valued goods and
services. It's this second type of

increase in GDP that we want. This isn't a
mirage, this is a real increase in GDP.

Real GDP measures the second type of
growth. And the Real GDP statistic, it

controls for inflation by adding up all
the goods and services produced in an

economy using the same set of prices over
time. The same set of prices. Real GDP

tells us - if, if the prices of goods and
services hadn't changed, how much would

GDP have increased, or decreased? Real GDP -
it's typically what we really care about.

Let's give an example. We'll be using a
fantastic tool called the St. Louis

Federal Reserve Economic Database, or
FRED. FRED is every economist's best

friend. So let's Google "US nominal GDP
Fred." Here's what we get. We can see that

we've grown from a GDP in 1950 of $320
billion, to a GDP in 2015 of over $17

trillion. Wow! That suggests that our
economy has gotten 55 times bigger. But

hold on, hold on, wait a moment, you might
say. My grandmother told me that a loaf of

bread used to cost a dime. And now it
costs a couple of dollars. That's right.

If we want to compare our economy over
time, we need to control for changes in

prices. So we don't want to look at
Nominal GDP. We're more interested in Real

GDP. So let's Google "Real US GDP Fred."
Here's what we get. This graph measures

Real GDP in 2009 dollars. That means using
2009 prices. This graph tells us that

using 2009 prices consistently, that in
1950, all the goods and services produced

at that time were worth about $2 trillion.
In comparison, in 2015, all the goods and

services produced at that time were worth
about $16 trillion. So while Nominal GDP

says that the economy is 55 times bigger
in 2015 than in 1950, Real GDP shows us

that it's 8 times bigger. That's still
pretty good, but a big difference between

Nominal GDP and Real GDP. Okay. So now
we've controlled for prices, but there's

another big difference in the US economy
in 1950 compared to today. Right - there's

a lot more people today. We can control
for the population size by using Real GDP

per capita, or per person. By dividing
Real GDP by a country's population, we get

a good, albeit imperfect, measure of the
average standard of living in a county. So

once again, let's Google, "Real GDP per
capita FRED." Here's what we get. In 1950,

Real GDP per capita, measured in constant
prices, was about $14,000. In 2015, Real

GDP per capita is about $50,000. So on
average, people in 2015 have a standard of

living that's four times higher than the
people in 1950. That's a pretty big and a

remarkable increase in the standard of
living. By the way, since Real GDP

increased by eight times, and Real GDP per
capita increased by four times, we know

immediately that the population
approximately doubled between 1950 and

2015. Now let's take a closer look at
this graph. We can see another reason why

we're interested in the GDP statistic.
Real GDP per capita declines during

recessions. In fact, a decline in Real
GDP is part of what defines a recession.

Declines in Real GDP also tend to be
accompanied by increases in unemployment.

You can see here that when Real GDP dips,
the unemployment rate spikes. Now here's

another nice feature of the FRED database.
On the Real GDP per capita graph, click

"Edit data series" and then switch to
percent annual changes. So now we can see

immediately the annual changes in Real
GDP. You can see, for example, the big

recession in 2008 and 2009. In 2009, for
example, the economy shrank by 3.6%

compared to the year before. That's a very
big and a very unpleasant decline. Okay.

So now you've got your hands around Real
GDP as a way of measuring the health of

our economy. And I said that Real GDP per
capita is a good, albeit imperfect,

measure of the average standard of living
in a country. But is that really true?

Does an increase in Real GDP per capita
mean that we're better off? That's the

view that I'm going to defend
in the next video.

- [Narrator] If you want to test yourself,
click "Practice Questions." Or, if you're

ready to move on, you can click "Go
to the next video." You can

also visit MRUniversity.com to see our
entire library of videos and resources.

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