Measuring the Economy 1

Gross Domestic Product (GDP)

Summary Gross Domestic Product (GDP)

The first step to calculating real GDP is choosing a base year. For example, to calculate the real GDP for in year 3 using year 1 as the base year, use the GDP equation with year 3 quantities and year 1 prices. In this case, real GDP is (10 X $1) + (9 X $6) = $64. For comparison, the nominal GDP in year 3 is (10 X $2) + (9 X $6) = $74. Because the price of bananas increased from year 1 to year 3, the nominal GDP increased more than the real GDP over this time period.

When comparing GDP between years, nominal GDP and real GDP capture different elements of the change. Nominal GDP captures both changes in quantity and changes in prices. Real GDP, on the other hand, captures only changes in quantity and is insensitive to the price level. Because of this difference, after computing nominal GDP and real GDP a third useful statistic can be computed. The GDP deflator is the ratio of nominal GDP to real GDP for a given year minus 1. In effect, the GDP deflator illustrates how much of the change in the GDP from a base year is reliant on changes in the price level.

For example, let's calculate, using , the GDP deflator for Country B in year 3, using year 1 as the base year. In order to find the GDP deflator, we first must determine both nominal GDP and real GDP in year 3.

Nominal GDP in year 3 = (10 X $2) + (9 X $6) = $74
Real GDP in year 3 (with year 1 as base year) = (10 X $1) + (9 X $6) = $64
The ratio of nominal GDP to real GDP is ( $74 / $64 ) - 1 = 16%.
This means that the price level rose 16% from year 1, the base year, to year 3, the comparison year.

Rearranging the terms in the equation for the GDP deflator allows for the calculation of nominal GDP by multiplying real GDP and the GDP deflator. This equation demonstrates the unique information shown by each of these measures of output. Real GDP captures changes in quantities. The GDP deflator captures changes in the price level. Nominal GDP captures both changes in prices and changes in quantities. By using nominal GDP, real GDP, and the GDP deflator you can look at a change in GDP and break it down into its component change in price level and change in quantities produced.

GDP is the single most useful number when describing the size and growth of a country's economy. An important thing to consider, though, is how GDP is connected with standard of living. After all, to the citizens of a country, the economy itself is less important than the standard of living that it provides.

GDP per capita, the GDP divided by the size of the population, gives the amount of GDP that each individual gets, on average, and thereby provides an excellent measure of standard of living within an economy. Because GDP is equal to national income, the value of GDP per capita is therefore the income of a representative individual. This number is connected directly to standard of living. In general, the higher GDP per capita in a country, the higher the standard of living.

GDP per capita is a more useful measure than GDP for determining standard of living because of differences in population across countries. If a country has a large GDP and a very large population, each person in the country may have a low income and thus may live in poor conditions. On the other hand, a country may have a moderate GDP but a very small population and thus a high individual income. Using the GDP per capita measure to compare standard of living across countries avoids the problem of division of GDP among the inhabitants of a country.