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GDP can be used to compare the economy at two points in time and calculate the rate at which a nation’s total output grows. In order to calculate the GDP growth rate from one year to the next, we divide the GDP for the second year by the GDP for the first year and subtract 1:
\(\text{GDP Growth Rate}= (GDP_2/GDP_1) - 1\)
For example, suppose that the entire output of an economy in one year consists of those 1 million magazines from our earlier example. If next year, the output is 1.1 million magazines and the cover price goes up to $10, then the GDP growth rate is calculated as:
\(\large{($10 \times 1.1M) \over ($9 \times 1M)} - 1 = \large{($11M) \over ($9M)} - 1 = .22 = 22\% \)
Real versus Nominal GDP
There is an obvious problem with this method of measuring economic growth: increases in the quantity of goods produced and increases in their prices both lead to increases in GDP. From the GDP growth rate, it is therefore hard to determine whether the growth is due to an increase in output quantity or an increase in prices. In the magazine example, the increase in output is only 10 percent, from 1M magazine copies to 1.1M.
Unfortunately, we can’t just ignore prices, because they enable us to total up many different types of output using money as a common unit. Suppose an economy produced 1M magazines and 500 oil tankers in year 1 and produced 1.1M magazines and 508 tankers in year 2. How would we calculate the percent increase in output without bringing prices into the picture?
Macroeconomists have solved this problem by defining two versions of GDP: nominal and real. Nominal GDP is the sum value of all produced goods and services at current prices. The preceding explanations use nominal GDP. Real GDP is the sum value of all produced goods and services adjusted for inflation. The simplest way to adjust for inflation is to stick with one year’s prices across multiple years. So, for instance, we could measure the growth of the magazines-and-tankers economy by comparing the total year 1 output using year 1 prices to the total year 2 output still using year 1 prices. This procedure is discussed further in the next chapter, where the difference between nominal and real GDP is used to construct an inflation measure called the GDP deflator.
Once we have a way to measure real GDP, we can use the growth rate of real, not nominal, GDP as a measure of true economic growth—that is, growth in productivity and prosperity. The real GDP growth rate adjusts for the effects of inflation.
The Business Cycle
Ideally, GDP growth would be nice and steady, at something like 3 percent per year (That’s the average growth rate of real U.S. GDP since 1950.) Realistically, GDP growth fluctuates. Sometimes, real GPD grows unusually fast, possibly over 10 percent per year. Periods of growth are called economic expansions. Other times, GDP growth may drop to zero or even go negative. A period when real GDP is declining is called a recession. If the recession is especially severe and prolonged, it is called a depression. The Great Depression, which was triggered by the stock market crash of 1929, lasted a full decade. (GDP was not actually shrinking that whole time, but it took until 1939 for GDP to climb back to its long-term trend line.)
The ups and downs of the GDP growth rate are sometimes called the business cycle. However, don’t get the idea that expansions and recessions alternate in a predictable, pendulum-like rhythm. They don’t. Predicting what the economy will be doing a few months from now is very hard, and the highly paid experts who make such predictions for a living are frequently wrong. The most a government can realistically hope to do is detect upturns and downturns early and minimize extreme swings in the GDP growth rate through appropriate policy measures. These measures are discussed in the chapters on Economic Policy.
